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SECTION A (QUESTION 1 IS COMPULSORY)


1.

Question 1


Firm "AAB" is considering investing in the production of a new product X. To this end

a

preliminary market research is undertaken that costs £400,000 in year 0. The

financial management of the firm expects that unit sales of the new product X will be

as follows: 75,000 units in year 1, 70,000 units in year 2, 120,000 units in year 3,

110,000

units in year 4, and 80,000 units in year 5. Production of the new product X

will require £1.5M (M=million) in net working capital (NWC) to start, which will be

completely recovered at the end of the 5 years. Total fixed costs are £800,000 per

year, variab

le production costs are £300 per unit, and the units are priced at £400

each. The equipment needed to begin production has an installed cost of £25M and

can be depreciated by using the straight

-

line depreciation method. At the end of the 5

years, this equi

pment can be sold for 20 per cent of its acquisition cost. Firm "AAB" is

in the 35 per cent marginal tax bracket and has a cost of capital of 15 per cent.


a)

Does the market research cost influence the project appraisal decision?

(5%)


b)

Calculate the Earnings

Before Interest and Taxes (EBIT) in each year, from year 1

to year 5.

(10%)


c)

Calculate the Net Cash Flow (NCF) in each year, from year 0 to year 5.

(10%)


d)

Calculate the Net Present Value (NPV) of the project at the discount rate of 15 per

cent. Should the

project be accepted according to the NPV method?

Top Answer

NPV = [NCF1/(1+r)+ NCF2/(1+r)^2+ NCF3/(1+r)^3...+ NCFn/(1+r)^n]-Initial Outlay... View the full answer

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