Reference no: EM132613323
Cook Ltd has been offered a contract to manufacture a specialist piece of equipment. The company's managers estimate that it will take three years to produce the equipment. The price offered is £1,200,000 expressed in current pounds sterling. This price will be increased in line with increases in the Retail Price Index during the contract period, and the adjusted amount will be paid in full when the equipment is delivered at the end of three years.
Production of the equipment will require the following resources:
A machine will be purchased immediately for £275,000 for exclusive use on this contract. The machine will have a scrap value at the end of three years of £40,000.
The contract will require four people to work on the project in the first year and ten people to work on the project in each of years two and three. Cook does not currently have sufficient employees to staff the project and as a result will have to recruit four people immediately and a further six people (to take the number to ten) at the end of the first year. The cost of recruiting is expected to be £2,400 per person and will be incurred at the time the employees start work (these costs will not be affected by inflation).
The total cost of employing one person is currently £32,000 per annum, based on wage rates which have recently been agreed for the coming year. The managers expect to negotiate wage rates at the end of one year to operate for the following two years. As a result, they expect that total employment costs per person for the second year of the contract will rise by a factor of 1.1 multiplied by the rate of increase in the Retail Price Index. (For example, if the Retail Price Index increases by 10% total employment costs will rise by 10% x 1.1, which equals 11%). Employment costs in year three are expected to be the same as those in year 2. You may assume that these employment costs are payable on the last day of the year to which they relate.
It is expected that the firm will incur redundancy costs of £4,000 per person at the end of the contract.
1,500 units of raw material X will be needed immediately and 1,500 units will be needed at the and of one year. Cook Ltd has 1,000 units of X in stock. These units originally cost £20 per unit and have a current replacement cost of £25 per unit. The company has no use for material X other than on the contract offered, and if the contract is rejected, the units in stock will be disposed of at an immediate cost of £12 per unit. (The material is highly specialised and cannot be re-sold). The cost of buying material X is expected to rise during the coming year by a factor of 1.2 multiplied by the rate of increase in the Retail Price Index.
Cook Ltd has a money discount rate of 10% per annum, which is not expected to be affected by any future change in the rate of inflation. The managers estimate that the Retail Price Index will increase at a rate of 6% per annum compound during the next three years.
(ii) The cash flows from the new project in year zero.
(iii)The cash flows from the new project in years 1 and 2.
(iv)The cash flows from the project in year 3.
(v) The NPV of the project.