The finance director of Ast Ltd is considering an investment in machinery to expand its production. The demand for the company's product has increased over the last few years and it has been necessary to sub-contract some of its production to another manufacturer. Last year Ast Ltd bought 15,000 units at a price per unit of £140 from this supplier. Next year it is anticipated that the demand faced by Ast Ltd will increase by a further 5,000 units, and this will increase the need for subcontracting unless the company's manufacturing capacity is extended.
Demand is not expected to expand further in subsequent years but it is anticipated that it will remain at the higher level for the next five years. It has been established that it would be possible to increase the level of purchases from the sub-contractor on the same terms as agreed for the initial 15,000 units. Ast's management anticipates that the p6roduct will be withdrawn from the market five years from now. It is expected that the final selling price obtained by Ast Ltd for its product will remain constant at £250 per unit over this time period.
The machinery necessary to produce the additional 20,000 units would cost £2 million and would be depreciated for tax purposes on a straight-line basis over a five year life. It is estimated that after five years the machinery would have a resale value of about £120,000.
The machinery would be located in the company's factory along with its existing machinery, and it would account for 10 per cent of the floor space.
There is considerable spare capacity in the factory and it is most unlikely that the company will have any alternative use for this unused capacity over the next five years. The company's production manager has produced the following estimates of costs per unit, but the finance director is not confident of his understanding of financial analysis:
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Labour expenses
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£28
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Raw materials
|
40
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Depreciation
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20
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Power etc.
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10
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Costs of space*
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8
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Direct overheads
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12
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General overheads
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12
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Overall costs per unit
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£130
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The company allocates a cost for the space occupied to each activity based on floor space
The added production would require an increase in working capital in the form of stocks, valued at cost, of £300,000. The tax rate is 20 per cent and the required rate of return is 18 per cent.
Determine the net present value of the investment, specifying your key assumptions.