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Question

Con Co introduced a new product, DV, to its range last year. The machine used to mold each item is a bottleneck in the production process meaning that a maximum of 5,000 units per annum can be manufactured.

All of the DV products produced are currently in demand due to their enormous commercial success. As a consequence of consumer feedback, the marketing department has created the following demand projection for upcoming years.

The directors are now thinking about purchasing a second machine to enable the business to meet the increased demand. Regarding this investment proposal, the following details have now been prepared:

The current selling price would be anticipated to last for the balance of the product’s life assuming manufacturing stayed at 5,000 units. However, it is anticipated that the selling price will decrease to $45 per unit for all sold units if manufacturing is raised. Once more, this will continue throughout the balance of the product’s lifespan.

No terminal value or machinery scrap value is expected at the end of four years, when production of DV is planned to end. For investment appraisal purposes, Con uses a nominal (money) discount rate of 10% per year and a target return on capital employed of 20% per year. Ignore taxation.

Required:

(a)Calculate the following values for the investment proposal:

(i) net present value; (ii) internal rate of return; (iii) return on capital employed (accounting rate of return) based on initial investment; and. (iv) discounted payback period.

(b)Discuss your findings in each section of (b) above and advise whether the investment proposal is financially acceptable.

SOLUTION

Con Co’s production process has a bottleneck in the machine used to mold each item of their new product, DV. This means that the maximum number of units that can be manufactured per year is 5,000.

The selling price of the product is currently $50 per unit and is expected to decrease to $45 per unit if manufacturing is increased. This price change is expected to last for the remaining lifespan of the product.