4 SC Co is evaluating the purchase of a new machine to produce product P, which has a short product life-cycle due
to rapidly changing technology. The machine is expected to cost $1 million. Production and sales of product P are
forecast to be as follows:
Year 1 2 3 4
Production and sales (units/year) 35,000 53,000 75,000 36,000
The selling price of product P (in current price terms) will be $20 per unit, while the variable cost of the product (in
current price terms) will be $12 per unit. Selling price inflation is expected to be 4% per year and variable cost
inflation is expected to be 5% per year. No increase in existing fixed costs is expected since SC Co has spare capacity
in both space and labour terms.
Producing and selling product P will call for increased investment in working capital. Analysis of historical levels of
working capital within SC Co indicates that at the start of each year, investment in working capital for product P will
need to be 7% of sales revenue for that year.
SC Co pays tax of 30% per year in the year in which the taxable profit occurs. Liability to tax is reduced by capital
allowances on machinery (tax-allowable depreciation), which SC Co can claim on a straight-line basis over the
four-year life of the proposed investment. The new machine is expected to have no scrap value at the end of the
four-year period.
SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.
Required:
(a) Calculate the net present value of the proposed investment in product P. (12 marks)
(b) Calculate the internal rate of return of the proposed investment in product P. (3 marks)
(c) Advise on the acceptability of the proposed investment in product P and discuss the limitations of the
evaluations you have carried out. (5 marks)
(d) Discuss how the net present value method of investment appraisal contributes towards the objective of
maximising the wealth of shareholders. (5 marks)
(25 marks)

4 (a) Calculation of net present value
Year 0 1 2 3 4
$ $ $ $ $
Sales revenue 728,000 1,146,390 1,687,500 842,400
Variable costs (441,000) (701,190) (1,041,750) (524,880)
––––––––– –––––––––– ––––––––––– –––––––––
Contribution 287,000 445,200 645,750 317,520
Capital allowances (250,000) (250,000) (250,000) (250,000)
––––––––– –––––––––– ––––––––––– –––––––––
Taxable profit 37,000 195,200 395,750 67,520
Taxation (11,100) (58,560) (118,725) (20,256)
––––––––– –––––––––– ––––––––––– –––––––––
After-tax profit 25,900 136,640 277,025 47,264
Capital allowances 250,000 250,000 250,000 250,000
––––––––– –––––––––– ––––––––––– –––––––––
After-tax cash flow 275,900 386,640 527,025 297,264
Initial investment (1,000,000)
Working capital (50,960) (29,287) (37,878) 59,157 58,968
––––––––––– ––––––––– –––––––––– ––––––––––– –––––––––
Net cash flows (1,050,960) 246,613 348,762 586,182 356,232
Discount at 12% 1·000 0·893 0·797 0·712 0·636
––––––––––– ––––––––– –––––––––– ––––––––––– –––––––––
Present values (1,050,960) 220,225 277,963 417,362 226,564
––––––––––– ––––––––– –––––––––– ––––––––––– –––––––––
NPV = $91,154

Workings
Sales revenue
Year 1 2 3 4
Selling price ($/unit) 20·80 21·63 22·50 23·40
Sales volume (units) 35,000 53,000 75,000 36,000
Sales revenue ($) 728,000 1,146,390 1,687,500 842,400
Variable costs
Year 1 2 3 4
Variable cost ($/unit) 12·60 13·23 13·89 14·58
Sales volume (units) 35,000 53,000 75,000 36,000
Variable costs ($) 441,000 701,190 1,041,750 524,880
Total investment in working capital
Year 0 investment = 728,000 x 0·07 = $50,960
Year 1 investment = 1,146,390 x 0·07 = $80,247
Year 2 investment = 1,687,500 x 0·07 = $118,125
Year 3 investment = 842,400 x 0·07 = $58,968
Incremental investment in working capital
Year 0 investment = 728,000 x 0·07 = $50,960
Year 1 investment = 80,247 – 50,960 = $29,287
Year 2 investment = 118,125 – 80,247 = $37,878
Year 3 recovery = 58,968 – 118,125 = $59,157
Year 4 recovery = $58,968
(b) Calculation of internal rate of return
Year 0 1 2 3 4
$ $ $ $ $
Net cash flows (1,050,960) 246,613 348,762 586,182 356,232
Discount at 20% 1·000 0·833 0·694 0·579 0·482
––––––––––– –––––––– –––––––– –––––––– ––––––––
Present values (1,050,960) 205,429 242,041 339,399 171,704
––––––––––– –––––––– –––––––– –––––––– ––––––––
NPV at 20% = ($92,387)
NPV at 12% = $91,154
IRR = 12 + [(20 – 12) x 91,154/(91,154 + 92,387)] = 12 + 4 = 16%
(c) Acceptability of the proposed investment in Product P
The NPV is positive and so the proposed investment can be recommended on financial grounds.
The IRR is greater than the discount rate used by SC Co for investment appraisal purposes and so the proposed investment
is financially acceptable. The cash flows of the proposed investment are conventional and so there is only one internal rate
of return. Furthermore, only one proposed investment is being considered and so there is no conflict between the advice
offered by the IRR and NPV investment appraisal methods.
Limitations of the investment evaluations
Both the NPV and IRR evaluations are heavily dependent on the production and sales volumes that have been forecast and
so SC Co should investigate the key assumptions underlying these forecast volumes. It is difficult to forecast the length and
features of a product’s life cycle so there is likely to be a degree of uncertainty associated with the forecast sales volumes.
Scenario analysis may be of assistance here in providing information on other possible outcomes to the proposed investment.
The inflation rates for selling price per unit and variable cost per unit have been assumed to be constant in future periods. In
reality, interaction between a range of economic and other forces influencing selling price per unit and variable cost per unit
will lead to unanticipated changes in both of these project variables. The assumption of constant inflation rates limits the
accuracy of the investment evaluations and could be an important consideration if the investment were only marginally
acceptable.
Since no increase in fixed costs is expected because SC Co has spare capacity in both space and labour terms, fixed costs
are not relevant to the evaluation and have been omitted. No information has been offered on whether the spare capacity
exists in future periods as well as in the current period. Since production of Product P is expected to more than double over
three years, future capacity needs should be assessed before a decision is made to proceed, in order to determine whether
any future incremental fixed costs may arise.
(d) The primary financial management objective of private sector companies is often stated to be the maximisation of the wealth
of its shareholders. While other corporate objectives are also important, for example due to the existence of other corporate
stakeholders than shareholders, financial management theory emphasises the importance of the objective of shareholder
wealth maximisation.

Shareholder wealth increases through receiving dividends and through share prices increasing over time. Changes in share
prices can therefore be used to assess whether a financial management decision is of benefit to shareholders. In fact, the
objective of maximising the wealth of shareholders is usually substituted by the objective of maximising the share price of a
company.
The net present value (NPV) investment appraisal method advises that an investment should be accepted if it has a positive
NPV. If a company accepts an investment with a positive NPV, the market value of the company, theoretically at least,
increases by the amount of the NPV. A company with a market value of $10 million investing in a project with an NPV of
$1 million will have a market value of $11 million once the investment is made. Shareholder wealth is therefore increased
if positive NPV projects are accepted and, again theoretically, shareholder wealth will be maximised if a company invests in
all projects with a positive NPV. This is sometimes referred to as the optimum investment schedule for a company.
The NPV investment appraisal method also contributes towards the objective of maximising the wealth of shareholders by
using the cost of capital of a company as a discount rate when calculating the present values of future cash flows. A positive
NPV represents an investment return that is greater than that required by a company’s providers of finance, offering the
possibility of increased dividends being paid to shareholders from future cash flows.

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