Question 1 – 80 marks
The senior management team of Tumbleware are considering an investment in a new project. The senior management team have provided the following information:
- The project is expected to last 4 years.
- There will be an immediate purchase of equipment costing €2m. It is estimated that the equipment will be sold for €200,000 at the end of the project.
- The equipment will be financed by a loan and interest of 8% is payable annually.
- Following initial market research costing €40,000, sales of the product are expected to be €1.1m in the first year increasing by 3% per annum. Tumbleware will earn a contribution of 45% on sales.
- Working capital requirement at the beginning of the project will be €320,000 with a further amount of €60,000 at the start of year 3.
- Existing fixed overheads of €25,000 per annum will be allocated to the project.
- The company’s depreciation policy is straight line with full year depreciation in year of acquisition and none in the year of sale.
- Capital allowances can be claimed at 10% per annum straight line.
- Tumbleware pays corporation tax of 12.5% on a current year basis.
- The cost of capital is 7%.
- Annual fixed overheads relating to the new project will be €15,000 per annum.
- Labour costs relating to the new project will be €35,000 per annum.
- Advertising costs of €7,000 are payable in year 1 and in year 4.
Requirement:
(a) Calculate the Net Present Value (NPV) of the project and advise management if the project should be undertaken. You should explain to management why you are/or are not recommending the project
(b) Explain why you have included OR excluded the following items in your calculation of NPV.
a. Interest on the loan
b. Market research
c. Existing fixed overheads
d. Advertising costs
(c) Calculate the payback period for the project.
(d) Outline and discuss three other factors which should be considered before investing in the project.
Question 2 – 20 marks
Discuss the advantages and disadvantages of BOTH the NPV and Payback method.
Sample Solution
