(Examination level) Pine Ltd have spent £20,000 researching the prospects for a new range of products. If it were decided that production is to go ahead an investment of £240,000 in capital equipment on 1 January 20X1 would be required.
The accounts department has produced budgeted profit and loss statements for each of the next five years for the project. At the end of the fifth year the capital equipment will be sold and production will cease.
The capital equipment is expected to be sold for scrap on 31.12.20X5 for £40,000.

When production is started it will be necessary to raise material stock levels by £30,000 and other working capital by £20,000.
Both the additional stock and other working capital increases will be released at the end of the project.
Customers receive one year's credit from the firm.
The overhead figures in the budgeted accounts have two elements - 60 per cent is due to a reallocation of existing overheads, 40 per cent is directly incurred because of the take-up of the project.
For the purposes of this appraisal you may regard all receipts and payments as occurring at the year end to which they relate, unless otherwise stated. The company's cost of capital is 12 per cent.
Assume no inflation or tax.
Required
a. Use the net present value method of project appraisal to advise the company on whether to go ahead with the proposed project.
b. Explain to a management team unfamiliar with discounted cash flow appraisal techniques the significance and value of the NPV method.

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Year end 31.12.20X1 31.12.20x2 31.12.20X3 31.12.20X4 31.12.20X5 Year end Year end Year end Year end Sales Materials Other variable costs 400 240 40 20 40 320 192 32 24 400 240 40 20 40 200 120 20 24 40 240 24 Depreciation Net profit/(loss) 32 All figures in 5000s)