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Appraisal Investment

BC plc is considering the introduction of a new breakfast cereal on which it has already spent £50,000 on technical and feasibility studies. The new product will be a variation of our current breakfast cereal, Crunch Stuff, with the exception that it will contain sugar-coated roasted nuts. Consequently, it will be called Crunch Stuff 'n' Nuts.

The following information describes the new product:

 Additional investment on new plant and equipment will amount to £1.5 million. The sum will be financed using £1 million 5-year bank loan at 6% rate of interest per annum, and £0.5 million from retained earnings. This ratio of financing is in line with our company's current gearing ratio.

 Production and sales, estimated from market research are projected as follows:

Year Units Produced and Sold

1 1,000,000
2 1,300,000
3 1,600,000
4 1,800,000
5 2,000,000

It is believed that about 10 percent of these projected sales will come from former Crunch Stuff customers who have switched to the new product.

 Sales price per unit: £2.50 in years 1-3, rising to £2.75 in year 4-5 in real terms.

 Variable costs, advertising and sales promotions: 50% of unit sales price in years 1-2, 52% in years 3-4, and 53% in year 5

 Annual fixed cost: £50,000 per annum, rising at 2% per annum. 20% of annual fixed costs come from a re-allocation of the annual fixed cost from existing product lines.

 Working capital: an initial working capital investment of £50,000 will be required just to get production started. For each year, the total investment in working capital will be equal to 10% of the value of sales.

 Depreciation method: use the simplified straight-line method over five years. It is assumed that the plant and equipment will have no salvage value after five years.

Other relevant information

 BC plc falls within 25% corporation tax band, and pays tax 12 months in arrears.

 BC plc currently has a nominal weighted average cost of capital of 15% after tax.

 The company appraises new project using nominal cash flows.

 Inflation rate in the UK over the next five year is project to be 2.5 percent per annum.

Required:

Mr. Alexander concluded his email to you by requesting to respond to the following questions:

a) How do sunk costs affect the determination of the cash flows associated with investment project?

b) Why do we focus on cash flows rather than accounting profits in making investment decisions?

c) Why should we be interested in incremental cash flows rather than total cash flows?

d) How should we calculate and treat working capital in investment appraisal?

e) How should we treat taxable depreciation allowance in investment appraisal?

f) Are financial charges and loan repayments relevant cash flows when using the net present value method of investment appraisal? Explain.

g) Why is it necessary for BC plc to finance the new product using both debt and equity capital in the same proportion as its current level of gearing?

h) How do we ensure consistency in the treatment of inflation in investment appraisal?

i) Derive the net cash flow of the new Crunch Stuff 'n' Nuts products. Show all workings and make clear any assumptions you make.

j) Is the new product financially viable on the basis of its net present value?

k) Using Excel, demonstrate and explain how you would evaluate the sensitivity of the project's NPV to changes in the estimates of unit sales price, annual sales volumes and variable costs.

l) What are the key merits and limitations of your analysis in (k) above?

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Required:

Mr. Alexander concluded his email to you by requesting to respond to the following questions:

a) How do sunk costs affect the determination of the cash flows associated with investment project?

Sunk Cost is a cost which is not impacted by the future. This is because sunk cost refers to that cost which has already been incurred and cannot be changed. Thus it does not affect the determination of cash flows associated with investment project.

b) Why do we focus on cash flows rather than accounting profits in making investment decisions?
Pitfalls of Net income as a criteria

It is Vague
It Ignores the Timing of Returns
It Ignores Risk
Assumes Perfect Competition

In new business environment profit maximization is regarded as
Unrealistic
Difficult
Inappropriate
Immoral.

Benefits of cash flow as a criteria

Maximizes the net present value of a course of action to shareholders.
Accounts for the timing and ...

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