Chapter 9: Discounted Cash Flow Techniques

Rome plc is considering buying a new machine in order to produce a new product. The machine will cost $1,800,000 and is expected to last for 5 years at which time it will have an estimated scrap value of $1,000,000. They expect to produce 100,000 units p.a. of the new product, which will be sold for $20 per unit in the first year.

Production costs per unit (at current prices) are: materials $8; labour $7. Materials are expected to inflate at 8% p.a. and labour at 5% p.a. Fixed overheads of the company currently amount to $1,000,000. The management accountant has decided that 20% of these should be absorbed into the new product. The company expects to be able to increase the selling price of the product by 7% p.a. An additional $200,000 of working capital will be required at the start of the project.

Capital allowances: 25% reducing balance. Tax: 25%, payable immediately (in the same year as the profit). Cost of capital: 10%. Calculate the NPV of the project and advise whether or not it should be accepted.

Work in $000, rounding each line to the nearest $000. Discount factors at 10%, years 1 to 5: 0.909, 0.826, 0.751, 0.683, 0.621.