XYZ Ltd has spent £100,000 on research and development of a new product, expected to have a short economic life of two years only. The product development manager has recommended this production opportunity for consideration at the company's board. She believes that the new product perfectly fits the firm's strategic plan. The new product has already attracted the strong interest of a rival business, and if XYZ Ltd decides not to go ahead with production, it can sell the patent rights to the competitor for £160,000. The marketing manager has suggested that annual revenues will depend on whether the demand for the new product is weak or strong, forecasting the following levels of annual demand and the independent probability of each level of demand for the two years of the project's life: Year 1 Probability Year 2 Sales (units) 450,000 Sales (units) Probability 0.2 350,000 300,000 100,000 0.3 350,000 0.3 0.3 200,000 90,000 0.3 0.2 0.2 90,000 0.2 Manufacture of the new product will require the immediate purchase of a new equipment costing £450,000. The interest charges on the money borrowed to finance the equipment are expected to be £15,000 per annum. The equipment will have a residual value of £50,000 on completion of the project. Each unit of the new product can be sold for £6. The variable costs per unit of the new product are £2.5. The fixed costs incurred each year for factory upkeep and administrative expenses are £40,000. These fixed costs are unlikely to change as a result of the decision to expand the company's existing product range. XYZ Ltd has an opportunity cost of finance of 6 per cent per annum. Given the variability of future sales figures, the finance director believes that in order to enhance confidence in the decision advice to the company's board, the appraisal of the investment project should allow for risk. Required: |(a) Using the expected net present value rule, advise the company on the financial feasibility of the proposed project in respect of its expected life of two years. Ignore tax and inflation.
XYZ Ltd has spent £100,000 on research and development of a new product, expected to have a short economic life of two years only. The product development manager has recommended this production opportunity for consideration at the company's board. She believes that the new product perfectly fits the firm's strategic plan. The new product has already attracted the strong interest of a rival business, and if XYZ Ltd decides not to go ahead with production, it can sell the patent rights to the competitor for £160,000. The marketing manager has suggested that annual revenues will depend on whether the demand for the new product is weak or strong, forecasting the following levels of annual demand and the independent probability of each level of demand for the two years of the project's life: Year 1 Probability Year 2 Sales (units) 450,000 Sales (units) Probability 0.2 350,000 300,000 100,000 0.3 350,000 0.3 0.3 200,000 90,000 0.3 0.2 0.2 90,000 0.2 Manufacture of the new product will require the immediate purchase of a new equipment costing £450,000. The interest charges on the money borrowed to finance the equipment are expected to be £15,000 per annum. The equipment will have a residual value of £50,000 on completion of the project. Each unit of the new product can be sold for £6. The variable costs per unit of the new product are £2.5. The fixed costs incurred each year for factory upkeep and administrative expenses are £40,000. These fixed costs are unlikely to change as a result of the decision to expand the company's existing product range. XYZ Ltd has an opportunity cost of finance of 6 per cent per annum. Given the variability of future sales figures, the finance director believes that in order to enhance confidence in the decision advice to the company's board, the appraisal of the investment project should allow for risk. Required: |(a) Using the expected net present value rule, advise the company on the financial feasibility of the proposed project in respect of its expected life of two years. Ignore tax and inflation.
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:Question 1
XYZ Ltd has spent £100,000 on research and development of a new product, expected to
have a short economic life of two years only. The product development manager has
recommended this production opportunity for consideration at the company's board. She
believes that the new product perfectly fits the firm's strategic plan. The new product has
already attracted the strong interest of a rival business, and if XYZ Ltd decides not to go
ahead with production, it can sell the patent rights to the competitor for £160,000.
The marketing manager has suggested that annual revenues will depend on whether the
demand for the new product is weak or strong, forecasting the following levels of annual
demand and the independent probability of each level of demand for the two years of the
project's life:
Year 1
Year 2
Probability
Sales (units)
350,000
Probability
Sales (units)
450,000
0.2
0.3
350,000
200,000
90,000
0.3
300,000
100,000
90,000
0.3
0.3
0.2
0.2
0.2
Manufacture of the new product will require the immediate purchase of a new equipment
costing £450,000. The interest charges on the money borrowed to finance the equipment are
expected to be £15,000 per annum. The equipment will have a residual value of £50,000 on
completion of the project.
Each unit of the new product can be sold for £6. The variable costs per unit of the new
product are £2.5. The fixed costs incurred each year for factory upkeep and administrative
expenses are £40,000. These fixed costs are unlikely to change as a result of the decision to
expand the company's existing product range.
XYZ Ltd has an opportunity cost of finance of 6 per cent per annum.
Given the variability of future sales figures, the finance director believes that in order to
enhance confidence in the decision advice to the company's board, the appraisal of the
investment project should allow for risk.
Required:
(a) Using the expected net present value rule, advise the company on the financial feasibility
of the proposed project in respect of its expected life of two years. Ignore tax and
inflation.
You must show computations and workings and state assumptions you have made
clearly and neatly.
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