BBMC $2023$ Decision Management

Question $2$

AB plc is considering a new product with a three$-$year life. The product can be made with existing

machinery, which has spare capacity, or by a labour$-$saving specialised new machine which would have

zero disposal value at the end of three years.

The following estimates have been made at current prices.

Additional fixed overheads for the new product are estimated to be $$3$ million per year.

The new machine would cost $$5$ million now and would halve the labour cost per unit.

Because of competition, selling price increases will be limited to $2\%$ per annum, although labour cost

is expected to rise at $12\%$ per annum and all other costs at $8\%$ per annum.

The company's money cost of capital is $15\%$ and, apart from the cost of the new machine, all other cash

flows can be assumed to arise at year ends.

Required:

$($a$)$ Calculate the NPV of the new product assuming that manufacture uses existing machinery.

$($b$)$ Calculate the NPV assuming that the new machine is purchased.

$($c$)$ Recommend what action should be taken, and comment on your recommendations.

$($d$)$ Explain what changes, if any, there would be in your analysis if the existing machinery was

already fully utilised on other production.

$($e$)$ Describe an appropriate method of comparing replacement proposals with unequal lives.