60.1K

Verified Solution

Link Copied!

Question A&B co Ltd is considering bringing to the market a new product. A market survey was commissioned to assess the potential demand for the product and this showed that product has an expected life of four years. The survey cost 50,000 and this is due for payment in four months time. On the basis of the survey information as well as internal management accounting information relating to costs, the assistant accountant prepared the following profit forecasts for the period.

YEAR	1 (,000)	2 (,000	3 (,000	4 (,000
Sales	190	200	190	135
Costs of sales	(115)	(145)	(110)	(95)
Gross profit	75	55	80	40
Variable overheads	(35)	(32)	(27)	(20)
Fixed overheads	(25)	(25)	(25)	(25)
Market survey written off	(40)	-	-	-
Net profit/(loss)	(25)	(2)	28	(5)

These profit forecasts were viewed with disappointment by the directors and there was a general feeling that the new product should not be launched. The Chief Executive pointed out that the product achieved profit in only one years of its four-year life and that over the four year period as whole, a net loss was expected. However, before a meeting that has been arranged to decide formally the future of the product, the following additional information became available:

(I) The new product will require the use of an existing machine. This has a written down value of 80,000 but could be sold for 60,000 immediately if the new product is not launched. If the new product is launched, it will be sold at the end of the four years period for 20,000.

(2) Addition working capital of 24,000 will be required immediately and will be needed over the four-year period. It will be released at the end of the period.

(3) The fixed overheads include a figure of 15,000 per year for depreciation of the machine and 5,000 per year for the re-allocation of existing overheads of the business.

The company has a cost of capital of 15%. Ignore taxation.

Required (a) Calculate the incremental cash flows arising from a decision to launch the product. (10marks)

(b) Calculate the approximate internal rate of return of the product. (10marsk) (c) Explain, with reasons whether or not the product should be launched (4marks) (d) Outline the strengths and weakness of internal the rate of return method as a basis for investment appraisal.(6marks)

Answer & Explanation Solved by verified expert

See Answer