Proton Plc operates in the domestic washing machine industry. The company manufactures and sells a component which is widely used in washing machines, the AB12.
The company has experienced declining demand for its product during the past two years. To avoid putting the company in financial distress due to declining demand for its product, the board of directors have decided to cease production of AB12 and introduce a new product in the market, the E520.
The board of Proton Plc are currently evaluating the financial viability of the project. The following financial forecast for the project has been provided below.
Financial Forecast for Project E520
The production of the E520 will require investment in new machinery amounting to Rs.1,125,000.
The old machine used in the production of the AB12 will no longer be needed and will be disposed of for Rs.102,500, payable immediately.
Four machine operators will lose their job once the new machine for E520 becomes operational. A redundancy payment of Rs.15,500 per machine operator is expected to be settled immediately.
Advertising costs incurred exclusively for product E520 are expected to be Rs.65,000 for the first three years of operation and Rs.60,000 thereafter.
Quality control cost will be incurred over the life of the project and are expected to be 5% of sales revenue.
Sales revenue and production cost for the first year are expected to be Rs.850,000 and Rs.340,000 respectively. These are expected to increase by 3% and 4.5% per annum thereafter.
Proton Plc pays tax on profits at a rate of 30% in the year in which the liability arises and claims capital allowances on machinery on a 25% reducing balance basis. Balancing allowances or charges are claimed only on disposal of assets.
The company has a weighted average cost of capital of 8.7%.
Proton Plc uses a five-year evaluation period for capital investment purposes, but expects the new product to continue to sell several years after the end of this period. Capital investments are expected to payback within three years on an undiscounted basis, and within four years on a discounted basis.
As a financial consultant, you have been approached by a group of shareholders who are extremely concerned about the current situation at the company, to prepare a report covering the following:
a) An evaluation of the financial viability of the new project using the following techniques:
i. Net present value
ii. Internal rate of return
iv. Discounted payback