Question 1 Play Co manufactures safety surfacing for children's playgrounds. The main raw material required is rubber particles and these are currently purchased from an outside supplier for $3.50 per tonne. This price is contractually guaranteed for the next four years. If the contract is terminated within the next two years, Play Co will be charged an immediate termination penalty of $150,000 which will not be allowed as a tax deductible expense. The directors are considering investing in equipment that would allow Play Co to manufacture these particles in house by using recycled tyres. The machine required to process the tyres will cost $400,000, and it is estimated that at the end of year four the machine will have a second-hand value of $50,000. The costs associated with the new venture are as follows: Variable costs (per tonne produced) Fixed costs (per annum) $0.80 $192,500 The additional fixed costs include maintenance costs of $40,000 and the additional depreciation charge (calculated on a straight-line basis over the life of the asset) relating to the machine. All of the above are quoted in current day terms. Inflationary increases are expected as follows: Variable costs Maintenance costs Other fixed costs 3% per annum 5% per annum 2% per annum The annual demand for the particles (based on the sales forecasts of the company) is: Demand (in tones) Year 1 100,000 Year 2 110,000 Year 3 130,000 Year 4 160,000 Corporation tax of 30% per year will be payable one year in arrears. Tax-allowable depreciation on a 25% reducing balance basis could be claimed on the cost of the equipment, with a balancing allowance being claimed in the fourth year of operation when the machine is disposed of. Required: (a) (b) Using 15% as the after-tax discount rate, advise Play Co on the desirability of purchasing the equipment. (Your workings should be shown to the nearest $000.) Identify and discuss the limitations of Net Present Value techniques when applied to investment appraisal.
Question 1 Play Co manufactures safety surfacing for children's playgrounds. The main raw material required is rubber particles and these are currently purchased from an outside supplier for $3.50 per tonne. This price is contractually guaranteed for the next four years. If the contract is terminated within the next two years, Play Co will be charged an immediate termination penalty of $150,000 which will not be allowed as a tax deductible expense. The directors are considering investing in equipment that would allow Play Co to manufacture these particles in house by using recycled tyres. The machine required to process the tyres will cost $400,000, and it is estimated that at the end of year four the machine will have a second-hand value of $50,000. The costs associated with the new venture are as follows: Variable costs (per tonne produced) Fixed costs (per annum) $0.80 $192,500 The additional fixed costs include maintenance costs of $40,000 and the additional depreciation charge (calculated on a straight-line basis over the life of the asset) relating to the machine. All of the above are quoted in current day terms. Inflationary increases are expected as follows: Variable costs Maintenance costs Other fixed costs 3% per annum 5% per annum 2% per annum The annual demand for the particles (based on the sales forecasts of the company) is: Demand (in tones) Year 1 100,000 Year 2 110,000 Year 3 130,000 Year 4 160,000 Corporation tax of 30% per year will be payable one year in arrears. Tax-allowable depreciation on a 25% reducing balance basis could be claimed on the cost of the equipment, with a balancing allowance being claimed in the fourth year of operation when the machine is disposed of. Required: (a) (b) Using 15% as the after-tax discount rate, advise Play Co on the desirability of purchasing the equipment. (Your workings should be shown to the nearest $000.) Identify and discuss the limitations of Net Present Value techniques when applied to investment appraisal.
Chapter1: Financial Statements And Business Decisions
Section: Chapter Questions
Problem 1Q
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Transcribed Image Text:Question 1
Play Co manufactures safety surfacing for children's playgrounds. The main raw material required is
rubber particles and these are currently purchased from an outside supplier for $3.50 per tonne. This
price is contractually guaranteed for the next four years. If the contract is terminated within the next two
years, Play Co will be charged an immediate termination penalty of $150,000 which will not be allowed
as a tax deductible expense.
The directors are considering investing in equipment that would allow Play Co to manufacture these
particles in house by using recycled tyres.
The machine required to process the tyres will cost $400,000, and it is estimated that at the end of year
four the machine will have a second-hand value of $50,000.
The costs associated with the new venture are as follows:
Variable costs (per tonne produced)
Fixed costs (per annum)
$0.80
$192,500
The additional fixed costs include maintenance costs of $40,000 and the additional depreciation charge
(calculated on a straight-line basis over the life of the asset) relating to the machine.
All of the above are quoted in current day terms. Inflationary increases are expected as follows:
Variable costs
Maintenance costs
Other fixed costs
3% per annum
5% per annum
2% per annum
The annual demand for the particles (based on the sales forecasts of the company) is:
Demand (in tones)
Year 1
100,000
Year 2
110,000
Year 3
130,000
Year 4
160,000
Corporation tax of 30% per year will be payable one year in arrears. Tax-allowable depreciation on a
25% reducing balance basis could be claimed on the cost of the equipment, with a balancing allowance
being claimed in the fourth year of operation when the machine is disposed of.
Required:
(a)
(b)
Using 15% as the after-tax discount rate, advise Play Co on the desirability of purchasing
the equipment. (Your workings should be shown to the nearest $000.)
Identify and discuss the limitations of Net Present Value techniques when applied to
investment appraisal.
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