Reference no: EM132976814

Company Z is assessing the purchase of a new item of machinery for the manufacture of a new consumer product. The machine will cost £1 million and will have a scrap value of £200,000 at the end of its useful life of five years.

The following information on an annual basis has been provided by the accountant to help inform the appraisal of the machine:

                                      £

Sales of consumer product 1.2m

Labour and materials costs (0.3m)

Overheads (0.2m)

Depreciation (0.03m)

Interest (0.02m)

Annual profit 0.65m

Additional Information:

• 50% of the overhead is incurred centrally and is not associated with the purchase of the machine
• The information provided above does not include the effects of inflation
• The rate of inflation is expected to be 2% and for a project in this risk class the money discount rate (including inflation) is 12.2%
• The machine is eligible for capital allowances, on a 25% reducing balance basis
• Corporate tax is payable at 30% and is charged in the same year that the cash flow occurs
• An additional investment in working capital of £250,000 would be immediately required and would be recoverable in the final year of the project

Required:

Problem a) Calculate the net present value (NPV) of the investment in the machine and recommend whether or not the investment should go ahead.

Problem b) Evaluate and discuss why NPV is considered to be theoretically superior to alternative methods of investment appraisal.

Problem c) Explain how capital rationing can be incorporated within the NPV method.