Question

Part-A

Scenario:

Midal cables limited, is currently considering the launch of a new product. A market survey was recently commissioned to assess the likely demand for the product and this showed that the product has an expected life of four years. The survey cost $30,000 and this is due for payment in four months’ time. On the basis of the survey information as well as internal management accounting information relating to costs, the assistant accountant prepared the following profit forecasts for the product.

Year	1	2	3	4
	$'000	$'000	$'000	$'000
Sales	180	200	160	120
Cost of sales	(115)	(140)	(110)	(85)
Gross profit	65	60	50	35
Variable overheads	(27)	(30)	(24)	(18)
Fixed overheads	(25)	(25)	(25)	(25
Market survey written off	(30)
Net profit/(loss)	(17)	5	1	(8)

         

These profit forecasts were viewed with disappointment by the directors and there was a general feeling that the new product should not be launched. The Chief Executive 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 has a written down value of$80,000 but could be sold for $70,000 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 $10,000.

Additional working capital of $20,000 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 $15,000 per year for depreciation of the machine and $5,000 per year for the re-allocation of existing overheads of the business.

The company has a cost of capital of 10%.

Ignore taxation.

Required

Use integrated financial software you are familiar with and perform the task below. For example, you may use excel spreadsheet for calculation and presentation of cash flow and Microsoft word to explain the phenomenon.

Calculate the incremental cash flows arising from a decision to launch the product.    

Calculate the approximate internal rate of return of the product.

Explain, with reasons, whether or not the product should be launched. (50-100 words)

Answer 1

Incremental cash flow:
All amount $'000
Year	1	2	3	4	Total
Net profit / (Loss)	-17	5	1	-8	-19
Add: Depreciation	15	15	15	15	60
Add: Reallocation of overheads	5	5	5	5	20
	3	25	21	12	61
Less: Working capital	20				20
	-17	25	21	12	41
Add: written off market survey cost	30
Add: Working capital to be recovered				20	20
Add: Scrap value of the machine				10	10
Net cash flow / (outflow)	13	25	21	42	101
Less: Cash flow from the sale of the machine if the product would not have launched					70
Incremental cash flow from the project					31

Approximate internal rate of return
Total return	31
Year	4
Annual return (31/4)	7.75
Investment	30
Approximate internal rate of return (7.75 x 100/30)	25.83%

All amount $'000
Year	1	2	3	4
Net profit / (Loss)	-17	5	1	-8
Add: Depreciation	15	15	15	15
Add: Reallocation of overheads	5	5	5	5
	3	25	21	12
Less: Working capital	20
	-17	25	21	12
Add: written off market survey cost	30
Add: Working capital to be recovered				20
Add: Scrap value of the machine				10
Net cash flow / (outflow)	13	25	21	42
PV factor @10% pa.	0.909091	0.826446	0.751315	0.683013
Present value of cash inflow	11.81818	20.66116	15.77761	28.68657
Present value of total cash inflow	76.94351
Less: Machine sale value	70
Net present value	6.943515

Since the net present value of the project, i.e. the product is positive as can be seen from the above calculation with NPV of $694352.00 the project should be accepted. This is important to understand that the depreciation is not cash expenses thus, the product will yield positive cash flow to the organization. Hence, the product should be accepted.