Financial Management

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C. George (Controls) Ltd manufactures a thermostat that can be used in a range of kitchen appliances. The manufacturing process is, at present, semi-automated. The equipment used cost £540,000 and has a carrying amount of £300,000. Demand for the product has been fairly stable and output has been maintained at 50,000 units a year in recent years.

The following data, based on the current level of output, have been prepared in respect of the product:

Using existing equipment

Per unit

 

 

£

£

Selling price

 

 

12.40

   Labour

 

(3.30)

 

   Materials

 

(3.65)

 

   Overheads:

Variable

(1.58)

 

 

Fixed

(1.60)

 

 

 

 

(10.13)

Operating profit

 

  2.27

Although the existing equipment is expected to last for a further four years before it is sold for an estimated £40,000, the business has recently been considering purchasing new equipment that would completely automate much of the production process. This would give rise to production cost savings. The new equipment would cost £670,000 and would have an expected life of four years, at the end of which it would be sold for an estimated £70,000. If the new equipment is purchased, the old equipment could be sold for £150,000 immediately.

The assistant to the business’s accountant has prepared a report to help assess the viability of the proposed change, which includes the following data:

Using new equipment

Per unit

 

 

£

£

Selling price

 

 

12.40

   Labour

 

(1.20)

 

   Materials

 

(3.20)

 

   Overheads:

Variable

(1.40)

 

 

Fixed

(3.30)

 

 

 

 

  (9.10)

Operating profit

 

   3.30

Depreciation charges will increase by £85,000 a year as a result of purchasing the new machinery; however, other fixed costs are not expected to change.

In the report the assistant wrote:

The figures shown above that relate to the proposed change are based on the current level of output and take account of a depreciation charge of £150,000 a year in respect of the new equipment. The effect of purchasing the new equipment will be to increase the operating profit to sales revenue ratio from 18.3% to 26.6%. In addition, the purchase of the new equipment will enable us to reduce our inventories level immediately by £130,000.

In view of these facts, I recommend purchase of the new equipment.

The business has a cost of capital of 12 per cent.

Required:

(a)Prepare a statement of the incremental cash flows arising from the purchase of the new equipment.

(b)Calculate the net present value of the proposed purchase of new equipment.

(c)State, with reasons, whether the business should purchase the new equipment.

(d)Explain why cash flow projections are used rather than profit forecasts to assess the viability of proposed capital expenditure projects.

Ignore taxation.

a)
We first have to calculate the potential variable cost savings per unit
££
Labor3.30-1.202.10
Materials3.65-3.200.45
Overheads1.58-1.400.18
2.73

Since the output is estimated at 50,000, the total variable cost savings would be (2.73*50,000) £136,500 per year.

We can now prepare the statement of the incremental cash flows arising from the purchase of the new equipment.

Year 0Year 1Year 2 Year 3Year 4
£000£000£000£000£000
Variable cost Savings per year136.5136.5136.5136.5
New Equipment(*1)(670)70
Old Equipment(*2)150(40)
Working capital(*3)130(130)
(390)136.5136.5136.536.5
*1 The new equipment will cost £670,000 and will be sold for £70 in four years *2 The old equipment could then be sold for £150.000 immediately without getting the initial £40,000 in four years * The new equipment would reduce the inventory level by £130,000 at same time increasing the working capital by the same number

(b)
We will calculate the NPV by multiplying the cash...
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