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BRT Co has developed a new confectionery line that can be sold for $5.00 per box and that is expected to have continuing popularity for many years. The Finance Director has proposed that investment in the new product should be evaluated over a four-year time-horizon, even though sales would continue after the fourth year, on the grounds that cash flows after four years are too uncertain to be included in the evaluation. The variable and fixed costs (both in current price terms) will depend on sales volume, as follows. Sales volume (boxes) less than 1 million 1–1.9 million 2–2.9 million 3–3.9 million Variable cost ($ per box) 2.80 3.00 3.00 3.05 Total fixed costs ($) 1 million 1.8 million 2.8 million 3.8 million Forecast sales volumes are as follows. Year 1 2 3 4 Demand (boxes) 0.7 million 1.6 million 2.1 million 3.0 million. The production equipment for the new confectionery line would cost $2 million and an additional initial investment of $750,000 would be needed for set-up. Ignoring inflation, selling price, variable costs, and fixed costs are expected to rise by 3% per year. The equipment could be sold for scrap at the end of year 4 and replaced with a newer machine. Expected scrap value of equipment at the end of four years is $600,000. BRT Co uses a cost of capital of 12% to appraise new investment projects.
Required: Assuming that production only lasts for four years, calculate the net present value of investing in the new product and advise on its financial acceptability.There is no point in simply typing up full question and expecting to be provided with a full answer. We do not offer that service.
You must have an answer in the same book in which you found the question so ask about whatever it is in the answer that you are not clear about and then I will explain.
Have you watched my free lectures on investment appraisal because everything needed to be able to answer this question is explained in my lectures.
This question is from a past Paper FM exam (not an AFM exam) and everything is therefore also explained also in my free Paper FM lectures!
I was concern toward, how the Variable cost and Fixed Cost increase by 3% every year ( 3%, 6%, 9%, 12%). Thank you in advance.
If the the costs are increasing by 3% per year, then for every $100 at current prices it will be 100 x 1.03 in 1 year, it will be 100 x (1.03^2) in 2 years, it will be 100 x (1.03^3) in 3 years, and so on.
If you are still unsure then do watch my free Paper FM lectures on investment appraisal with inflation, because this is revision from Paper FM.
Thank you it was helpful. I have another question regarding. ” CHARM CO, Kaplan Kit “.
Charm Inc., a software company, has developed a new game, ‘Fingo’, which it plans to
launch in the near future. Sales of the new game are expected to be very strong, following a
favourable review by a popular PC magazine. Charm Inc. has been informed that the review
will give the game a ‘Best Buy’ recommendation. Sales volumes, production volumes and
selling prices for ‘Fingo’ over its four-year life are expected to be as follows:
Year
Sales and production (units)
Selling price($ per game)
1 – 150,000
2 – 70,000
3 – 60,000
4 – 60,000
Financial information on ‘Fingo’ for the first year of production is as follows:
Direct material cost – $5.40 per game
Other variable production cost – $6.00 per game
Fixed costs – $4.00 per gameAdvertising costs to stimulate demand are expected to be $650,000 in the first year of
production and $100,000 in the second year of production. No advertising costs are
expected in the third and fourth years of production. Fixed costs represent incremental
cash fixed production overheads. ‘Fingo’ will be produced on a new production machine
costing $800,000. Tax allowable depreciation will be claimed on a reducing balance basis at
a rate of 25%. The machine will have a useful life of four years at the end of which no scrap
value is expected.
Charm Inc. pays tax on profit at a rate of 30% per year and tax liabilities are settled in the
year in which they arise.Qs: Regarding the fixed cost, why they take fixed cost constant from Y1 to Y4, as number of unit changes. Why don’t we multiply ( 4 * units of each year ) to fixed cost per year. Thank you
In future please start a new thread when you are asking about different questions.
The definition of a fixed cost (as you should remember from Paper MA) is that the total cost does not change with the level of production. That is what makes it a fixed cost as opposed to a variable cost.
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