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Investment decision

The board of Fashions Unlimited has to choose between two models of plant. Current production with the existing plant is of very poor quality.

Plants Existing Model I Model II
Additional Investment £0 £5,000 £12,000
Variable Unit Costs £5 £4 £3

Further relevant details available are:
i. Existing demand 2,000 units.
ii. Selling price £16.
iii. Annual demand for the product with the improved quality could rise to 5,000 units; capable of being satisfied with Models I or II, but not with the existing plant.
iv. Estimated economic life of the product is 3 years, at the end of which the plants will have no salvage value.
v. Capital allowances available are only in the form of an annual allowance of 20% p.a. straight line.
vi. Effective rate of corporation tax is estimated at 40%, with one year lag in cash payment for tax.
vii. Appropriate cost of capital is 8%.
viii. The board expects no inflation.
ix. All capital allowances on the existing machine have already been used.

a. Stating any assumptions you need to make, assist Fashions Unlimited in their investment decision.
b. How does your recommendation depend on annual demand?


Solution Preview

Fashions Unlimited needs to choose between the two models:
For this we need to make some assumptions:
First, the variable unit cost has been given to us in the table; however, the fixed cost has not been given to us. We can use any reasonable amount as fixed cost, so we use a convenient figure that is £11.
Secondly, we have not been given the demand for the product after new plants are in operation so we make an assumption that the annual demand actually rises to 5000. As part B of the question says, this assumption is important because if the demand falls to a level where the contribution from the new model equals the cost of capital plus the depreciation, then the net contribution may become zero and any lower demand would lead to net losses. So it ...

Solution Summary

An investment decision is scrutinized.