Problem:

Dev Co is measuring the purchase of new machine to manufacture product P, which has a short product life-cycle because of rapidly changing technology. The machine is anticipated to cost Rs1 million. Production and sales of product P are forecast to be as follows:

• The selling price of product P (in current price terms) will be Rs20 per piece, while the variable cost of product (in current price terms) will be Rs12 per piece. Selling price inflation is expected to be 4% per year and variable cost inflation is expected to be 5% per year. No raise in existing fixed costs is expected since Dev Co has spare capacity in both space and labour terms.

• Producing and selling product P will call for raised investment in working capital. Analysis of historical levels of working capital within Dev Co indicates that at start of each year, investment in working capital for product P will require to be 7% of sales revenue for that year.

• Dev Co pays tax of 30% per year in the year in which the taxable profit takes place. Liability to tax is decreased by capital allowances on machinery (tax-allowable depreciation), which Dev Co can claim on the straight-line basis over the 4-year life of proposed investment. The new machine is expected to have no scrap value at the end of 4-year period.

• Dev Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.

Required:

1. Compute the net present value of proposed investment in product P.

2. Compute the internal rate of return of proposed investment in product P.

3. Describe how the net present value technique of investment appraisal contributes towards the objective of maximising wealth of shareholders.