Muggins is evaluating a project to produce a new product. The product has an expected life of four years.
Costs associated with the product are expected to be as follows.
Variable costs per unit
Labour: $30
Materials:
6 kg of material X at $1.64 per kg
3 units of component Y at $4.20 per unit
Other variable costs: $4.40
Indirect cost each year
Apportionment of head office salaries $118,000
Apportionment of general building occupancy $168,000
Other overheads $80,000, of which $60,000 represent additional cash expenditures (including rent of
machinery)
To manufacture the product, a product manager will have to be recruited at an annual gross cost of
$34,000, and one assistant manager, whose current annual salary is $30,000, will be transferred from
another department, where he will be replaced by a new appointee at a cost of $27,000 a year.
The necessary machinery will be rented. It will be installed in the company's factory. This will take up space that would otherwise be rented to another local company for $135,000 a year. This rent (for thevfactory space) is not subject to any uncertainty, as a binding four-year lease would be created. 60,000 kg of material X are already in inventory, at a purchase value of $98,400. They have no use other than the manufacture of the new product. Their disposal value is $50,000. Expected sales volumes of the product, at the proposed selling price of $125 a unit, are as follows.
Year Expected sales Units
a. 10,000
b. 18,000
c. 18,000
d. 19,000
All sales and costs will be on a cash basis and should be assumed to occur at the end of the year. Ignore taxation.
The company requires that certainty-equivalent cash flows have a positive NPV at a discount rate of 5%.
Adjustment factors to arrive at certainty-equivalent amounts are as follows.
Year Costs Benefits
a. 1.1 0.9
b. 1.3 0.8
c. 1.4 0.7
d. 1.5 0.6
Required: Assess on financial grounds whether the project is acceptable.
