NCO Berhad (NCO) is a manufacturer of high-quality tools for those working in the engineering industry. The mission statement of the company declares that it is dedicated to maximizing the wealth of its shareholders and, since it was formed in 2019, the company has grown rapidly. Recently, the company has developed a new type of drill and the directors of the company are now considering whether this drill should be manufactured and sold. The following information is available to help evaluate the viability of the new product: i. Costs incurred in designing and developing the new drill, which have all been paid, were RM300,000. These costs are to be written off in equal instalments against profits generated over the new product s expected life of four years. ii. Sales are expected to be 20,000 drills per year over the next four years. The selling price of each drill will be RM50 in the first three years and RM40 in the final year. iii. Variable operating costs are estimated to be RM20 for each drill. iv. Additional fixed operating costs are expected to be RM250,000 per year. v. New equipment costing RM500,000 (with estimated salvage value of RM20,000 at the end of year 4) has to be purchased immediately to produce the new product. The equipment will be sold at the end of four years for RM10,000. vi. Additional working capital of RM150,000 will be required immediately to support the manufacture of the new product. This will be released at the end of the life of the new product. The company uses the net present value method to evaluate new investment opportunities. The company uses a cost of capital of 10%. Year Discount rate 10% 1 0.909 2 0.826 3 0.751 4 0.683 Assume that NCO is subject to a 20% corporation tax and that all cash flows occur at the end of the year except for the initial investment. Also, assume that straight-line depreciation is used for tax purposes and that any tax associated with the disposal of machinery occurs at the same time as the related transaction. Required: a) Determine the relevant after-tax cash flows for the production of new drills at each of the following three points: i) project initiation, ii) project operation, iii) project disposal. b) Based on the calculations in (a), use the net present value method to determine whether NCO should produce the new drills. c) Evaluate the investment criteria adopted by the business against discounted payback method and state, with reasons, why the NPV method should prevail and the new drill should be produced.
NCO Berhad (NCO) is a manufacturer of high-quality tools for those working in the engineering industry. The mission statement of the company declares that it is dedicated to maximizing the wealth of its shareholders and, since it was formed in 2019, the company has grown rapidly. Recently, the company has developed a new type of drill and the directors of the company are now considering whether this drill should be manufactured and sold.
The following information is available to help evaluate the viability of the new product:
i. Costs incurred in designing and developing the new drill, which have all been paid, were RM300,000. These costs are to be written off in equal instalments against profits generated over the new product s expected life of four years.
ii. Sales are expected to be 20,000 drills per year over the next four years. The selling price of each drill will be RM50 in the first three years and RM40 in the final year.
iii. Variable operating costs are estimated to be RM20 for each drill.
iv. Additional fixed operating costs are expected to be RM250,000 per year. v. New equipment costing RM500,000 (with estimated salvage value of RM20,000 at the end of year 4) has to be purchased immediately to produce the new product. The equipment will be sold at the end of four years for RM10,000.
vi. Additional working capital of RM150,000 will be required immediately to support the manufacture of the new product. This will be released at the end of the life of the new product.
The company uses the
The company uses a cost of capital of 10%.
| Year | Discount rate 10% |
| 1 |
0.909 |
| 2 |
0.826 |
| 3 |
0.751 |
| 4 |
0.683 |
Assume that NCO is subject to a 20% corporation tax and that all cash flows occur at the end of the year except for the initial investment. Also, assume that straight-line
Required:
- a) Determine the relevant after-tax cash flows for the production of new drills at each of
the following three points:
i) project initiation,
ii) project operation,
iii) project disposal.
b) Based on the calculations in (a), use the net present value method to determine whether NCO should produce the new drills.
c) Evaluate the investment criteria adopted by the business against discounted payback method and state, with reasons, why the NPV method should prevail and the new drill should be produced.
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