Question

The product development department of Dalglish plc is contemplating renting a factory building on a four-year lease from 1 January Year 1, investing in some new plant and using it to produce a new product, code named DAG7. Since there appears to be no possibility of the plant continuing to be economically viable beyond a four-year life, it has been decided to assess the new product over a four-year manufacturing and sales life.

Under the lease the business will pay £100,000 annually. The plant is expected to cost £600,000. This will be bought and paid for on 1 January Year 1 and is expected to be scrapped (with zero proceeds) on 31 December Year 4. The business will depreciate this asset, in its accounts, on a straight-line basis (25 per cent each year).

Each unit of DAG7 is estimated to give rise to a variable labour cost of £200 and a variable material cost of £100. DAG7 manufacture will be charged with an annual share of the business’s administrative costs, totalling £150,000 each year. Manufacture and sales of DAG7s are expected to increase total administrative costs by £90,000 each year.

Manufacture and sales of DAG7s are expected to be as follows:

Year Ending 31 December	Year	Units of DAG7
	1	400
	2	600
	3	500
	4	200

These will be sold for an estimated £1,400 each.

For investment appraisal purposes you should assume that all cashflows relating to revenue and costs occur at the end of the year to which they relate.

The business’s accounting year end is 31 December each year. It has been decided, given the level of risk involved with the project to use a discount rate of 15 per cent a year.

An extract from the present values tables is given here:

Discount Factor	Year 1	Year 2	Year 3	Year 4
10%	0.909	0.826	0.751	0.683
15%	0.870	0.756	0.658	0.572
20%	0.833	0.694	0.579	0.482
25%	0.800	0.640	0.512	0.410
30%	0.769	0.592	0.455	0.350

Required

1. Identify the annual net relevant cash flows and use this information to assess the project on a net present value basis at 1 January Year 1.                                                          

2. Estimate the internal rate of return of the project.                                                           

3. Identify any other factors that Dalglish plc should consider when evaluating whether to proceed with this project, and recommend whether or not you believe the investment in DAG7 should be undertaken.                                                                                                 

Answer 1

	Dalglish Plc.
	Investment Apprisal
	We are not considering part of the allocation of share of Buisness admin cost as relevant cash flow
	Total Admin cost increase in Pound 90000 specific to this project , rest 60000 (of total 150000)
	will not be relevant for cash flow cosndieration as that cost os already existing and not incremental cost.
	Assuming zero tax as nothing mentioned about tax.
	Depreciation excluded from cash flow as it is non cash spend
	All numbers in Pound
		Year 0	Year 1	Year 2	Year 3	Year 4
	Sales units		400	600	500	200
	Sales Revenue at unit price 1400		560,000	840,000	700,000	280,000
	Relevant Cash flow Details	Year 0	Year 1	Year 2	Year 3	Year 4
1	Initial Investment in Plant	(600,000)
	Cash flow fropm Operations
	Sales Revenue		560,000	840,000	700,000	280,000
	Direct Material cost @100/unit		40,000	60,000	50,000	20,000
	Direct Labor @200		80,000	120,000	100,000	40,000
	Lease Rental		100,000	100,000	100,000	100,000
	Business Admin cost (relevant incremental cost)		90,000	90,000	90,000	90,000
2	Net Cash flow from Operations		250,000	470,000	360,000	30,000
3	Total Cash flow=1+2	(600,000)	250,000	470,000	360,000	30,000
4	Discount factor @15% =1/1.15^n	1.000	0.870	0.756	0.658	0.572
5	PV of cash flows =3*4=	(600,000)	217,500	355,320	236,880	17,160
6	NPV =	226,860	ans i
	PI =	38%
	If we use discount rate 34.8197% , the NPV becomes zero	=NPV(34.8197%,F1083,G1083,H1083,I1083)+E1083
ii	so the IRR of the project is 34.8197% approx
iii	I shall also consider the discounted payback period and that is
	years and close to half of project life
	%Profitability Index is also quite good=
	IRR is much higher that required rate of return.
	So considering NPV, IRR, discounted payback and PI factors, we can recommend the investment in the project.