Question

Kako Ltd is considering introducing a new product unto the market. This will require the injection of capital to the tune of GH¢20,000 for the purchase of the equipment for production. The cost of the building that Kako Ltd intends to use for the project is GH¢30,000. The Production and Marketing department has presented the information in the table below:

2019
Variable cost per unit of the product
GH¢2
Selling price per unit
GH¢6
Quantity
4000 units per annum

Again the following information should be taken not of:

Feasibility studies cost the company GH¢2000

Test marketing expenses amounts to GH¢3000

Variable cost will increase by 5% per annum

Selling price will increase by 10% per annum

Marketing expense will be 5% of sales revenue per year

An initial working capital investment of GH¢2000 will be made. Subsequently, net working capital at the end of each year will be equal to 10 percent of sales for that year. In the final year of the project, net working capital will decline to zero as the project is wound down. In other words, the investment in working capital is to be completely recovered by the end of the project’s life

As a result of the introduction of the new product, sales of existing products will drop by 1000 units per annum. The selling price per unit of existing products is GH¢5 while the variable cost is GH¢ 4.

Overhead cost will be fixed at GH¢6000 per year

The project will last for five years (2019-2023) and the machines will be sold for a scrap value of GH¢2000

Charge depreciation using the straight line method

CPC falls within the 25% tax bracket

The project cost of capital is 15%

Required:

Evaluate the project using NPV and advise the Management of Kako Ltd whether or not it should introduce the new product

Answer 1

Year	0	1	2	3	4	5
Initial Inflow	-20000
Sales Unit		4000	4000	4000	4000	4000
Sales Price		6	6.6	7.26	7.986	8.7846
Variable Cost		2	2.1	2.205	2.31525	2.431013
Marketing Exp		0.3	0.33	0.363	0.3993	0.43923
Profit per unit		3.7	4.17	4.692	5.27145	5.914358
Total Profit		14800	16680	18768	21085.8	23657.43
Overhead Cost		6000	6000	6000	6000	6000
Depreciation		3600	3600	3600	3600	3600
Net Profit		5200	7080	9168	11485.8	14057.43
Tax @ 25%		1300	1770	2292	2871.45	3514.358
PAT (NP - Tax)		3900	5310	6876	8614.35	10543.07
Depreciation		3600	3600	3600	3600	3600
Operating cash flow (PAT + Dep)		7500	8910	10476	12214.35	14143.07
Working Capital Change (10% x SP)	-2000	4400	240	264	290.4	319.44
Recovery of Working Capital						3513.84
Recovery of scrap value						2000
Loss of contribution (1000 x (5-4))		1000	1000	1000	1000	1000
Net cash flow	-22000	2100	7670	9212	10923.95	18337.47
PV of cash flow @ 12%	-22000	1826.087	5799.622	6057.04	6245.804	9116.965
NPV	7045.516996

NOTE : The following assumptions have been taken

1. Cost of building is not an out of pocket cost therefore it has not been included in the calculations.

2. Feasibility study and test marketing expense are sunk cost therefore have been ignored.

3. Assumed that the loss of contribution is not subject to increase in sales price and increase in variable cost in absence of express information in the same regard.

4.Assumed that the working capital employed is fully recovered at the end of 5th year.