Calculate the net present value of buying the machine

Assignment Help Financial Accounting

Reference no: EM133327560

Case: Edlar Services ltd. makes components for electronic equipment and has recently tendered for a contract to supply an item to a satellite navigation equipment manufacturer.

In order to produce the component Edlar Services ltd. would have to purchase a special machine at a cost of £280,000, at the end of 2022. It is expected, due to the obsolescence of such equipment as satellite navigators, that the contract to manufacture the component will only last for 4 years. After that time, it is thought that the machine will not have a great deal of use and will only be disposed of for £5,000.
Demand for the component is expected to be a follows:

2023 2024 2025 2026
Demand (units) 38,000 42,000 50,000 23,000
The selling price of the component is expected to be £11.00 per unit and the variable cost of
production will be £7.50 per unit with incremental annual fixed overheads of £35,000. All of these
forecasts are quoted in current terms.
The general rate of inflation over the relevant period is expected to be 5% per year but Edlar
Services ltd. have forecast that their selling price and costs will inflate as follows each year:
Selling price 3% per annum
Variable cost of production 4% per annum
Fixed production overheads 6% per annum
Edlar Services ltd. is aware that their investors are expecting a real rate of return of 5.7% per annum.

The company operates with a target Capital Employed of 20% and depreciation is charged on a straight-line basis over the life of an asset.

Required:
a) Calculate the net present value of buying the machine and comment on your findings. Should you accept this project based on NPV or reject?

b) Calculate the internal rate of return (based on a higher rate of return 19%) of the investment and comment on your findings. Should you accept this project based on IRR or reject?

c) Production Manager of Edlar Services ltd. is heard to say, "When I was on a financial-decision making course at DMU we were told that it is much easier to appraise projects using the Payback and Accounting Rate of Return methodologies." There was no immediate response from the other employees as many of them could not understand the conversation.

Provide an analytical response to the Production Manager's comment, contrasting the four appraisal methods (i.e., Payback, ARR, NPV and IRR) with his suggestions. This should be a written discussion and requires no additional calculations.

Reference no: EM133327560

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