Question

MJM Ltd is considering the launch of a new product after an extensive market research whose costs were K22,000. The research cost is due for payment in a months’ time. The management accountant has prepared the following forecasts for the product.

Year 1 2 3 4

K K K K

Sales 220,000 200,000 180,000 120,000

Material cost. (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:

i. 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 K90,000 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 K20,000.

ii. If the product is launched, a marketing cost of K2,000 per year will be incurred due to social media adverts expected to be used. This cost is included in the projected fixed overhead value reported each year.

iii. Additional working capital of 15% of sales revenue each year will be required throughout the four-year period. It will be released at the end of the investment period.

iv. 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.

v. All the values above are in money terms except for variable overheads which are in current price terms. Variable overhead inflation is 2% per year.

vi. The money cost of capital is 11%. Ignore taxation.

Required:

a) Identify the relevant cash flows associated with the decision to launch the new product and determine the net cash flows for each year (year 0 to 4).

b) Calculate the Net present value (NPV).

c) Determine the approximate internal rate of return (IRR).

d) Comment on the proposal to launch the new product.

e) Briefly discuss why you have omitted specific figures in (a) above (if any).

Answer 1

if IRR is to be calculated without excel, find NPV for two rate of discount and using proportion, calculate NPV = 0.

Make sure that the relevant cost is only to be considered for decision making. Hope it's clear!