S.T. Ilton Co Ltd manufactures a special cheese, the current manufacturing cost and selling price of which is:
|
Selling price
|
£
|
£
200
|
(per 100 kg)
|
|
Variable manufacturing costs Fixed costs (based on annual
output of 2,000,000 kg)
|
160
20
|
180
|
(per 100 kg)
|
Profit 20 (per 100 kg)
Because of the nature of the product it is only made to order. However, it is considered that the company could extend its current sales and output of 2,000,000 kg by investing in some special storage facilities. As a result, the company would be able to sell immediately from stock an additional 1,000,000 kg of cheese each year. Because the orders would be supplied immediately, the company may be able to charge a special sales premium over the existing selling price for the additional 1,000,000 kg. The premium is difficult to estimate with any certainty, it could be as high as 30% or it could be nil. The probability distribution shown below is the marketing directo's best estimate of the possible sales premium likely to be obtained.
Selling price premium over current price
%
0
10
20
30
Probability
0.20
0.30
0.30
0.20
The new storage facilities would incur additional fixed expenses each year of £100,000, and working capital required immediately would increase by £250,000. The total cost of the equipment would be £1,500,000, with an 8 year life and a nil scrap value.
You are required to evaluate the project to extend the storage facilities using the NPV method, assuming the company's cost of capital is 20%.