Reference no: EM133164249

Light Saver Ltd - investment appraisal question

Light Saver Ltd is a well-established producer and fitter of house and industrial electrical equipment. The company is planning to produce a new lighting system to sell for businesses in the EU Zone at £150 each.

If the plan is approved, the project will require additional machinery costing £7,000,000 that will last for five years. Other machinery will be necessary but fortunately is already at hand; if this to be scrapped it is unlikely to fetch more than £10,000. At the end of the project all the machinery will be sold for an estimated £50,000, and all remaining stock of goods will be liquefied for an estimated £60,000.At the beginning of the project it will be necessary to spend £200,000 on building up stock.

It is expected that 60,000 Lighting Systems will be sold in each of the five years of the project. The accountant has worked out the costs per unit:

Selling price                                                                             £150

            Materials and components                                           £55

            Variable labour cost                                                     £15

            Variable overhead                                                       £10

            Depreciation                                                                £10

                                                                                                            £90

            Profit                                                                                       £60

Implementing the new Lighting System project will require the following fixed costs:
- Annual maintenance of £300,000 per year.
- Advertising will be £150,000 in the first year and £50,000 in subsequent years.
- The new project requires recruiting a project manager at £45,000 per year. However, as a result of his recruitment the company will save £2,000 per month on consultants' fees.

The company wants to benefit from your expertise and would like to base their decision whether to undertake the project or not on your advice. Taking into account that the cost of capital is 10%, and that their required internal rate of return from any project is 20%, you are required to:

a) Identify the relevant cash flows for the project

b) Calculate the payback period for this project

c) Calculate the Net Present Value (NPV) of the project

d) The internal rate of return for this project is 28%. Based on this, and your calculations above, what advice would you give to Light Saver Ltd with regard to manufacturing the new Lighting System?