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Net Present Value - See the attached file.
Sleep-Easily Ltd manufactures high quality, branded orthopaedic furniture in Manchester. The products are made in limited numbers and for limited production periods of usually no more than six years. All products are sold on the Web, supported by speciality magazine advertising. A significant part of the overhead is concerned with the costs of promotion and is shared between up to 70 product items at any one time.
The directors are currently reviewing a number of new product proposals:
A) Recliner chair
D) Small armchair (special lumbar support)
E) Three-seater sofa
The following information concerning costs and prices for each unit of production in £s:
3 seater sofa
1 Overheads are allocated on the basis of machine hours. Overheads include an average of £40 per item for packaging and delivery.
The marketing department's estimate of annual sales in units for each product are:
The 'recliner chair' production (product A) requires the purchase and installation of new equipment costing a total of £38,500. This equipment will have a value in use to the firm of about £13,500 at the end of the six-year product run. The two armchairs (products C & D) and the sofa (product E) will be manufactured using equipment which has many years of life left and which is being underutilised at present. The footstools (product E) can be manufactured using a machine that was otherwise intended for sale immediately for £3,500. However, this equipment has just three years of life left and it is anticipated that it will be replaced at the end of three years at a cost of £14,000 (the equipment will have an estimated value of £6,000 when trolley production ceases six years from now).
The recliner (product A) will also use up most of a stock of springs and hinges that are otherwise redundant. Four springs and four hinges are needed on each recliner. The springs each have a cost of £1.05 and the hinges each cost £0.90, both are already included in the estimate of material cost for the recliner.
Ignore taxation and inflation. The company has a required rate of return of 18% on all of its projects.
You should be able to identify the relevant cash flows and apply basic capital budgeting methods to guide your decision making.
1. Calculate the net present value for each of the five products.
2. With the exception of product D, the small armchair, all of the products will be replacing existing items in the company's current catalogue. How, if at all, should this influence the decision to manufacture? (Note that the company sees the products as not necessarily selling as stand alone units because customers often combine items to make a suite when placing an order).
3. An opportunity has arisen to sell to a leading department store chain extra thirty recliners for each of the next six years during which production is being considered. Leaving aside distribution and marketing issues associated with moving from Web-only based sales, do you recommend that the company pursue this business and if yes, what is the minimum 'factory gate' price per unit that it should request?
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