Reference no: EM132565991

Question - Sycamore Ltd is evaluating the purchase of a new machine to produce product X, which will have a 4-year product life-cycle. Production and sales of product X are forecast to be 40000,50000,70000,32000 for the 4-year product life-cycle.

The selling price of product X in current price terms will be £50 per unit, while the variable cost of the product in current price terms will be £40 per unit. Selling price inflation is expected to be 5% per year and variable cost inflation is expected to be 6% per year. No increase in existing fixed costs is expected since Sycamore Ltd has enough spare capacity in both space and labour terms to undertake this project.

However, producing and selling product X will require working capital investment equal to 10% of the expected sales revenue. This investment must be in place at the start of each year. Hence, working capital requirement for year 1 should be in place in year zero and so forth. At the end of the project, any remaining investment in working capital is no longer required and will be recovered.

The cost of the machinery, payable at the start of the first year (end of year zero) will be £1 million and will attract capital allowances (tax-allowable depreciation) of 40% on a reducing balance basis. At the end of the 4-year period, the machinery will be sold for £200,000.

Sycamore Ltd pays tax on profits at an annual rate of 30%. One half of the tax payable in a year is paid during the year and the remainder is paid the following year. The company uses a nominal (money terms) after tax cost of capital of 20% for investment appraisal purposes.

REQUIRED - Calculate the net present value (NPV) of the proposed investment in product X and advise on the acceptability of the project.