Sensitivity analysis, Financial Management

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A division of Saron plc is considering introducing a new product.  The product is the result of work undertaken by the division's research and development department - the expenditure incurred on the development of the product already amounts to £1.60 million.  The market for the product has been assessed while the work on its development has been undertaken. The latest market research information suggests that sales in the first year should be about 0.25 million units, rising to 0.50 million units in year two and staying at this level for the subsequent three years. It is anticipated that demand will begin to fall off by year six and is expected that the end of that year, with more technologically advanced products likely to be available, the product will be withdrawn from the market. Sales in year six are expected to be around 0.30 million. To generate the demand for the product it will be necessary to spend £1.80 million on advertising and marketing when it is launched and to spend £0.50 million in each of years one to five. The product is expected to sell for £40.00 per unit. Whilst this new product's life is limited it is expected to provide the company with valuable experience of a new market.

The level of sales now anticipated is lower than the level expected when the research on the product began, and this means that the project's profitability will now be lower than initially anticipated. This has prompted some members of the board of directors to suggest that it was a mistake to have undertaken the development work and company should now abandon its plans to manufacture and market the product.

To manufacture the product it will be necessary to invest £8.00 million in equipment.  This equipment will be depreciated for tax purposes on a straight-line basis over ten years, a longer period than the anticipated life of the product.  It is anticipated that the equipment it will have a residual value of about £1.50 million at the end of the six year period.  The production facility will be located in one of the company's existing factories. The space in the factory concerned is not fully occupied and there sufficient spare capacity to accommodate the manufacture of the new product. The company's management accounting system will allocate the division responsible for the investment an annual charge of £0.04 million for this space. This is based on the estimated rental cost of a building of this nature and the floor space the manufacturing process will occupy.

 Use will be made of a finishing machine that the company already owns. This has been used in the production of other products, but is no longer required. It is fully depreciated for tax purposes and has an estimated re-sale value of £0.2 million. If it is used in the proposed investment the estimated resale value is expected to fall to £0.05 million by the end of year six.

The direct production costs per unit are estimated to be £25 per unit, comprising 40 per cent labour costs and 60 per cent raw material and component costs. The fixed costs directly attributable to the production are expected to be £0.5m per annum. Each product sold by the company is allocated an overhead charge equivalent to 10 per cent of sales revenue.  The company's accountant contends that overheads stemming from the company's research and expenditure and head office expenses have to be covered and this is an equitable way of dealing with the costs.  At the beginning of each year the company will need to hold stocks of the finished product equivalent to 20 per cent of expected unit sales and stocks of raw materials and components equivalent to 25 per cent of the requirements for production. It will not be necessary to obtain additional warehouse space for storage purposes as there is adequate space available in the factory. The increase in debtors as a result of introducing the product will be just about offset by the increase in creditors.

The company requires a rate of return of 14 per cent on investments of this nature, and the tax rate is 40 per cent.

a)  Determine the investment's net present value, internal rate of return, and payback period. Specifying and discussing your assumptions and their implications for your analysis in detail.

b)   Explain what is meant by sensitivity analysis, use sensitivity analysis to identify the critical determinants of the NPV of the proposed investment, and interpret your results.


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