Question

Fine Chemicals plc has recently received an invitation to produce a new chemical for supply to a textile manufacturer. The invitation is to produce 15,000 kg each year for the next three years at a price of £42 a kg. The following information has been collected which will help the directors to reach a decision on whether to accept the invitation or not:

(1)New plant costing £200,000 will need to be bought and paid for at the start of production. This will have a residual value of £10,000 at the end of the third year.

(2)Ten new workers will be taken on for the duration of production. Recruitment costs, payable at the start of the production period will total £20,000. The workers will be paid compensation for being made redundant at the rate of £3,000 per worker, payable at the end of the production period. During the production period the workers will be paid £200,000 in total each year.

(3)It is estimated that the production of the new chemical will give rise to an increase of £18,000 in overheads.

(4)Production will require the use of an ingredient, known as X15G, at the rate of 6,000 kg each year. The business already has a stock of 4,000 kg. This was originally bought for £15 per kg. This was bought for a previous contract that had to be abandoned. If the stock of X15G is not used in production of the new chemical there is no other use for it and it will be disposed of immediately. It will cost £2 per kg to dispose of the X15G. The cost of new X15G is £20 per kg.

(5) Production will also require the use of 9,000 kg each year of another ingredient, known as Y23D. The business already has 9,000 kg in stock, which cost £25 per kg. Recently the buying price has dropped to £20 per kg. Y23D is used in large quantities on a number of the business’s current products.

(6) Assessing the investment in the plant is to be undertaken on the basis of a finance cost of 12% each year.

(7) The above data were discovered by a consultant who is to be paid a total of £2,000 for the work. Treat cash flows relating to revenue, overheads, stock purchases and labour as occurring at the end of the relevant year.

Required:

Produce calculations which show, on the basis of net present value, whether the new chemical should be produced or not and state your conclusion.

Answer 1

		NOTE:	2,000	to be paid to the consultant is sunk cost and not relevant
		Initial Cash Flow:
		Cost of plant	(200,000)
		Recruitment cost to be paid at start	(20,000)
		Total Initial Cash flow	(220,000)
		Cost of X15G in Year 1
		Saving in disposal cost for 4000 kg	8,000	(4000*2)
		2000 kg of new purchase	40,000	(2000*20)
		Net Cost of X15G in Year 1	32,000	(40000-8000)
		Cost of X15 G in Year 2 and year 3	120,000	(6000*20)
		Cost of material Y23D in year 1:	225,000	(25*9000)
		Cost of material Y23D in year 2 and year 3	180,000	(20*9000)
		Annual Cash Flow
	N	Year	1	2	3
	A	Increase in annual revenue(15000*42)	630,000	630,000	630,000
	B	Payment to   new workers	200,000	200,000	200,000
	C	Increase in overhead cost	18,000	18,000	18,000
	D	Cost of Material X15G	32,000	120,000	120,000
	E	Cost of Material Y23D	225,000	180,000	180,000
	F=A-B-C-D-F	Net increase in annual cash flow	155,000	112,000	112,000
		TERMINAL CASH FLOW
		Residual value of plant	10,000
		Compensation to redundant workers	-30,000	(3000*10)
		Total Terminal cash Flow	-20,000
		Present value(PV) of Cash Flow
		(Cash flow)/((1+i)^N)
		i=discount rate=finance cost=12%=0.12
		N= year of cash flow
		YEAR WISE CASH FLOWS AND PRESENT VALUE
	N	YEAR	0	1	2	3
	G	Total Initial Cash Flow	(220,000)
	F	Annual Cash Flows		155,000	112,000	112,000
	H	Terminal Cash Flow				-20,000
	I=G+F+H	NET CASH FLOW	(220,000)	155,000	112,000	92,000	SUM
	PV=I/(1.12^N)	Present Value of Net Cash Flow	(220,000)	138,393	89,286	65484	73162
	NPV=Sum of PVs	Net Present Value	73162
		On the basis of net present value, the new chemical should be produced
		NPV is POSITIVE