ERS Ltd is considering the launch of a new product after an extensive market research whose...
ERS Ltd is considering the launch of a new product
after an extensive market research whose costs were K20,000. The
research cost is due for payment in a months’ time. The management
accountant has prepared the following forecasts for the
product.
Year 1234
Sales
Material cost.
Variable overheads.
Fixed overheads.
Market research cost expensed. Net profit/(loss).
215,000 (115,000)
(27,000) (25,000) (20,000)
(7,000)
200,000 (140,000)
(30,000) (25,000)
5,000
150,000 (110,000)
(24,000) (25,000)
1,000
120,000 (85,000) (18,000) (25,000)
(8,000)
KKKK
The CEO pointed out that the product achieved profits in only two
years of its four-year life and that over the four-year period as a
whole, a net loss was expected. However, before a meeting that had
been arranged to decide formally the future of the product, the
following additional information became available:
i. The new product will require the use of an existing machine.
This machine was acquired some time back for K400,000 and has since
been depreciated down value to a book value of K80,000. The machine
can be sold for K90,000 immediately if the new product is not
launched. If the product is launched, it will be sold at the end of
the four-year period for K15,000.
ii. If the product is launched, a marketing cost of K1,000 per year
will be incurred due to social media adverts expected to be used.
This cost is included in the projected fixed overhead value
reported each year.
iii. Additional working capital of 10% of sales revenue each year
will be required through- out the four-year period. It will be
released at the end of the investment period.
iv. The fixed overheads include a figure of K15,000 per year for
depreciation of the machine and K5,000 per year for the
re-allocation of existing overheads of the business.
v. All the values above are in money terms except for variable
overheads which are in current price terms. Variable overhead
inflation is 2% per year.
vi. The money cost of capital is 11%. Ignore taxation.
2
Required:
a) Identify the relevant cash flows associated with the decision to
launch the new
product and determine the net cash flows for each year (year 0 to
4).
b) Calculate the Net present value (NPV).
c) Determine the approximate internal rate of return (IRR).
d) Comment on the proposal to launch the new product.
e) Briefly discuss why you have omitted specific figures in (a)
above (if any).
Homework Answers
| ERS | ||||
| Schedule of Profit / Loss on the product for the year 1-4 | ||||
| Amount in K | ||||
| Year | 1 | 2 | 3 | 4 |
| Sales | 215,000 | 200,000 | 150,000 | 120,000 |
| Material cost. | 115,000 | 140,000 | 110,000 | 85,000 |
| Variable overheads. | 27,000 | 30,000 | 24,000 | 18,000 |
| Fixed overheads. | 25,000 | 25,000 | 25,000 | 25,000 |
| Market research cost expensed. | 20,000 | - | - | - |
| Total costs | 187,000 | 195,000 | 159,000 | 128,000 |
| Net profit/(loss). | 28,000 | 5,000 | (9,000) | (8,000) |
| TOTAL PROFIT | 16,000 | |||
| The net profit loss given for the Year 1 and 3 have been wrongly computed in the question. Hence calcaulations are made after rectifying the same . | ||||
| a & b | ||||
| Computation of relevant cash flows associated with the decision to launch the new product | ||||
| Year | 1 | 2 | 3 | 4 |
| Estimated profit/ loss ( From Table above) | 28,000 | 5,000 | (9,000) | (8,000) |
| Add: Research costs | 20,000 | |||
| Less: Additional working capital required ( 10% of sales revenue ) | 21,500 | 20,000 | 15,000 | 12,000 |
| Add: Depreciation ( Non cash ) | 15,000 | 15,000 | 15,000 | 15,000 |
| Add: Reallocated Overheads | 5,000 | 5,000 | 5,000 | 5,000 |
| Less: Inflation @ 2% pa on Variable OH | - | 600 | 480 | 360 |
| Net Cash profits | 46,500 | 4,400 | (4,480) | (360) |
| Add: Release of WC | 68,500 | |||
| Add: Sale of Equipment | 15,000 | |||
| Total Cash flow/outflow | 46,500 | 4,400 | (4,480) | 83,140 |
| PVF @ 11% | 0.9009 | 0.8116 | 0.7312 | 0.6587 |
| DCF - NPV | 41,892 | 3,571 | (3,276) | 54,767 |
| NET PRESENT VALUE OF CASH FLOWS | 96,954 | |||
| If Machine is sold immediately | ||||
| Sale value received immediately | 90,000 | |||
| So it is better to launch the product as the project gives a higher positive NPV | ||||
| The assumptions for calculations have been mentioned in (e ) below. | ||||
| b)Calculation of IRR : | ||||
| IRR is the internal rate of return I,e the rate at which if the discounting of cash flows is done , the NPV is equal to 0. | ||||
| It is the minimum rate required to make the project a no profit no loss . | ||||
| The NPV is positive when we use the cost of capital as a discounting factor . So for the NPV to be zero or negative , a lower rate of return is required. The same can be done by trial or error , method or by using formula | ||||
| Year | 1 | 2 | 3 | 4 |
| Cash flows | 46,500 | 4,400 | (4,480) | 83,140 |
| PVF @ 14.2% | 0.88 | 0.77 | 0.67 | 0.59 |
| 40,748.37 | 3,378.84 | (3,012.50) | 48,954.47 | |
| The value without launch is 90,000 and with launch is 96,954 , hence we need to find the IRR in between . | ||||
| The approximate IRR will be 14.2% | ||||
| d) The proposal should be launched . | ||||
| e) | ||||
| Notes : | ||||
| 1. Incremental approach has been used and hence the profits calculated above have been adjusted . | ||||
| 2. The marketing costs have been excluded as they have to be paid irrespective of launch of product . | ||||
| 3. Depreciation has been added back as it is a non cash item. | ||||
| 4 The total of additional working capital has been released at the end of the 4th year. | ||||
| 5 The book value of Equipment is | 80,000 | |||
|
Depreciation charged in 4 years = 15000 x 4 |
60,000 | |||
| Thus Book value at the end of 4th year | 20,000 | |||
| Less: Residual value at the end of 4th year | 15,000 | |||
| Loss on sale | 5,000 | |||
| 5. Loss on sale has been ignored as the tax has to be ignored . | ||||
|
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