Problem:
Jyoti Textile is considering whether to add a new product to its range. Machinery costing $280,000 would have to be bought at the start of the project (Year 0). The project life would be five years with no residual value at the end of the project.
Sales of the new product are forecast at 12,000 units in each of Years 1 and 2, rising to 15,000 units in each of Years 3, 4 and 5. The selling price per unit will be $15 in Year 1 and $16 thereafter. Variable costs are estimated at $9 per unit.
Straight-line depreciation of the machine would be $56,000 in each year. No other future incremental fixed costs would be incurred. However, the company has already incurred expenditure of $6,000 for a market research survey and has decided to write this off against profits made in the first year if the investment takes place.
Assume that all cash flows, apart from the investment in machinery, occur at the end of each year.
The cost of capital is 14% per annum. The company has a policy of investing in projects having a payback period of 3 years or less.
Required:
(a) Calculate the pay back of the project (Year 0 to 5).
(b) Calculate the net present value of the project (working in $000).
(c) Calculate the internal rate of return of the project.
(d) Based on methods in (a) and (b) above, state in each case whether the project should be undertaken.