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Question 1
The finance director of Pendine Ltd has been asked to evaluate an investment in the facilities
required to manufacture a new product developed by the company’s R&D Department. The
development of the product has cost the company £250,000 and it has been established that the
patent for the product could be sold for £500,000. To manufacture the product it will be necessary
to invest £8 million in machinery that will be located in one of the company’s existing buildings
in which there is considerable unused space. The company’s internal accounting system allocates
rental costs to all production activities based on the space utilised, and for this product the charge
will be £40,000 per annum. The machinery will be depreciated on a straight-line basis over five
years for tax purposes and is expected to have resale value of £0.5 million. The product is
expected to be sold at a price per unit of £25 and sales are expected to be 300,000 units per annum
for each of the next five years. Variable costs per unit have been estimated at £12 while fixed
costs of £600,000 per annum are anticipated. The company’s accounting system also allocates
overheads to each production activity on the basis of 10 per cent of revenues. Working capital
requirements are expected to be about £1.8 million. The required rate of return is 14 per cent and
the tax rate is 30 per cent.
a) Determine the NPV of the proposed investment.
b) Explain that is meant by sensitivity analysis and determine the sensitivity of the
investment’s NPV to deviations in the expected price from the assumed value of
£25 per unit.
c) Explain the treatment in your analysis of overheads, R&D costs, and the investment
in machinery
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