Question

Muggins is evaluating a project to produce a new product. The product has an expected life of four years.

Costs associated with the product are expected to be as follows.
Variable costs per unit
Labour: $30
Materials:
6 kg of material X at $1.64 per kg
3 units of component Y at $4.20 per unit
Other variable costs: $4.40
Indirect cost each year
Apportionment of head office salaries $118,000
Apportionment of general building occupancy $168,000
Other overheads $80,000, of which $60,000 represent additional cash expenditures (including rent of
machinery)
To manufacture the product, a product manager will have to be recruited at an annual gross cost of
$34,000, and one assistant manager, whose current annual salary is $30,000, will be transferred from
another department, where he will be replaced by a new appointee at a cost of $27,000 a year.
The necessary machinery will be rented. It will be installed in the company's factory. This will take up space that would otherwise be rented to another local company for $135,000 a year. This rent (for thevfactory space) is not subject to any uncertainty, as a binding four-year lease would be created. 60,000 kg of material X are already in inventory, at a purchase value of $98,400. They have no use other than the manufacture of the new product. Their disposal value is $50,000. Expected sales volumes of the product, at the proposed selling price of $125 a unit, are as follows.
Year Expected sales Units
1 10,000
2 18,000
3 18,000
4 19,000
All sales and costs will be on a cash basis and should be assumed to occur at the end of the year. Ignore taxation.
The company requires that certainty-equivalent cash flows have a positive NPV at a discount rate of 5%.
Adjustment factors to arrive at certainty-equivalent amounts are as follows.
Year Costs Benefits
1 1.1 0.9
2 1.3 0.8
3 1.4 0.7
4 1.5 0.6
Required: Assess on financial grounds whether the project is acceptable.

Answer 1

To decide on the financial acceptability of creating a new product, a detailed calculation involving variable costs, indirect costs, opportunity costs, and salary expenses is required. Adjusting these projected cash flows for uncertainty to achieve certainty-equivalent amounts and computing the NPV at a 5% discount rate will give a clear result. If the NPV is positive, the project is financially viable.

Step-by-step explanation:

A student is evaluating the financial acceptability of a project to produce a new product over a four-year period. Important considerations in this assessment include the calculation of variable costs, indirect costs, the opportunity cost of space, and costs associated with salaries and machinery rental. Given that all sales and costs will occur at the end of each year and ignoring tax implications, the project must yield a positive NPV at a 5% discount rate, using specific adjustment factors for certainty-equivalent cash flows.

To determine whether the project is financially viable, we need to consider cash flow projections factoring in the expected sales units and selling price, adjust costs and benefits for uncertainty, and calculate the project's Net Present Value (NPV). These calculations involve a detailed analysis of the provided cost components, such as labor, materials, overheads, and the cost of occupying factory space that could otherwise generate rental income. The costs of existing inventory and the hiring of new staff, such as a product manager and replacement staff in another department, should also be accounted for. After adjusting the cash flows, if the final NPV exceeds zero, the project can be considered financially acceptable.