Tufty plc produces a small range of industrial pumps using automated methods. The business is now considering production of a new model of pump, starting on 1 January 20X3. The business wishes to assess the new pump over a four-year timescale.

Production of the new pump will require the use of automated production equipment.

This production equipment could be bought new, on 31 December 20X2, for a cost of £1 million. As an alternative to buying new production equipment, the business could use some equipment that it already owns. This is proving surplus to requirements, owing to a recent downturn in demand for another of the business’s products.
This downturn is expected to continue for the foreseeable future.
The surplus production equipment could be sold for an estimated £400,000 on 1 January 20X3. It was bought new in 20X0 for £1 million. If it were used on production of the new pumps, it would be expected to have a zero market value by 31 December 20X6.
If the equipment for the new pumps were to be bought new in 20X2, it would be disposed of on 1 January 20X7. It is expected to have a total realisable value of £400,000 on that date.
The production equipment has been, and/or will be, eligible for capital allowances, calculated on a reducing balance basis, at 25 per cent p.a., starting in the year of acquisition irrespective of the exact date of acquisition during the year. In the year of disposal, no tax depreciation is charged, but the difference between the written down value and the disposal proceeds is either given as an additional tax allowance or charged to tax according to whether the written down value exceeds the disposal proceeds or vice versa.
Fixed annual incremental costs, excluding depreciation, of producing the new pump would total £80,000. Variable annual costs would be £200,000 if the new production equipment is to be used, but £300,000 were the existing production equipment to be used, since the existing production equipment is less automated and would require a higher labour input.
Sales of the new pumps would be expected to generate revenues of £600,000 for each of the four years.
Production of the new pump is expected to give rise to an additional working capital requirement of 10 per cent of annual revenues. These amounts will need to be in place by 1 January of the relevant year and will be released on 31 December 20X6.
It is not expected that any other incremental costs would be involved with the decision to produce the new pump.
The directors have a target after-tax return of 10 per cent p.a. for all activities.
All revenues and expenses should be treated as if they occurred on the last day of the relevant calendar year, except where the date is specifically stated. The corporation tax rate is estimated at 30 per cent for the relevant period. Tax cash flows occur on 31 December in the year in which the events giving rise to them occur.

(a) Prepare a schedule that derives the annual net relevant cash flows arising from producing the new pump and use this to assess the decision on the basis of net present value. You should make clear whether the surplus production equipment should be sold or used on production of the new pump on 1 January 20X3.

(b) Assess, and comment on, the sensitivity of the estimate of the fixed annual incremental costs of producing the new pump to the decision reached in (a).
(Ignore inflation.)