Reference no: EM132782079
Dolly Ltd is contemplating renting a factory on a four-year lease from 1 January 2018, investing in some new plant, and using it to produce a new product code-named GS7. Since it seems impossible for the plant to stay economically viable beyond a four-year life, it has been decided to assess the new product over a four-year manufacturing and sales life.
- Under the lease the business will pay $100,000 annually in advance on 1 January. The plant is expected to cost $600,000. This will be bought and paid for on 1 January 2018 and is expected to be scrapped with zero proceeds on 31 December 2021. The business will depreciate this asset, in its accounts, on a straight-line basis at 25% per year.
- Each unit of GS7 is estimated to give rise to a variable labour cost of $200 and a variable material cost of $100. GS7 manufacture will be charged with an annual share of the business's administrative costs, totaling $150,000 a year. Manufacture and sales of GS7s is expected to increase total administrative costs by $90,000 each year.
Manufacture and sales of GS7s are expected to be as follows:
Year ended 31 December Year Units of GS7
2018 ------ 400
2019 ------600
2020 ----- 500
2021 ------200
These will be sold for an estimated $1,400 each.
The business will need to support the manufacture and sales of the product with working capital. This has been estimated at an amount equivalent to $100 per unit of the product sold each year. The working capital would need to be in place by the beginning of the relevant year of production and sales, and reduced to zero at the end of 2021.
The business's accounting year-end is 31 December. It has been decided, given the level of risk involved with the project, to use a discount rate of 15%.
Problem (a) Identify the annual net relevant cash flows, and use this information to assess the project on a net present value basis at 1 January 2018.
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