Reference no: EM133360259

Case: Baxter plc plans to buy a new machine to meet expected demand for a new product, Product S. This machine will cost £250,000 and last for four years, at the end of which time it will be sold for £5,000. Baxter plc expects demand for Product S to be as follows:

Year??? 1?? 2?? 3?? 4
Demand (units)??35,000??40,000??50,000??25,000

The selling price for Product S is expected to be £12.00 per unit and the variable cost of production is expected to be £7.80 per unit. Incremental annual fixed production overheads of £25,000 per year will be incurred. Selling price and costs are all in current price terms.

Selling price and costs are expected to increase as follows:

??? ??? Increase
Selling price of Product S:???3% per year
Variable cost of production:???4% per year
Fixed production overhead:???6% per year

Other information
Baxter plc has a real cost of capital of 5.7% and pays tax at an annual rate of 30% one year in arrears. It can claim capital allowances on a 25% reducing balance basis. General inflation is expected to be 5% per year.

Baxter plc has a target return on capital employed of 20%. Depreciation is charged on a straight-line basis over the life of the asset.

Required:

Question 1: Calculate the capital allowances available to Baxter plc.

Question 2: Calculate the tax payable by Baxter plc if it proceeds with the project.

Question 3: Calculate the net present value of buying the new machine and comment on your findings.

Question 4: Calculate the before-tax return on capital employed (accounting rate of return) using the average net book value method and comment on your findings.

Question 5: Discuss the strengths and weaknesses of the accounting rate of return method in appraising capital investments.