Lothian Engineering Ltd has been offered a contract to supply one of its components to a company developing
a new product. The contract would be for 400 units per annum for five years at a price of £600 per unit. Lothian
does not have the capacity to fulfil the contract requirements and it would be necessary to invest in additional
machinery. The company's management accountant believes that the estimates of the production costs can be
based on those incurred in the manufacture of the product already being produced. The following estimates per
unit are provided:
• Materials and components £180
• Labour £100
• Overheads (variable) £20
• Overheads (allocation of fixed general overheads) £40.
In addition, fixed costs of £25,000 per annum would be incurred. The investment in machinery required to
produce the additional output would cost £160,000. This expenditure can be depreciated for tax purposes over
the five-year life of the contract on a straight-line basis and it is anticipated that it could be sold for £50,000 at
the end of the five year period.
The company would also make use of some equipment it already owns. This is fully depreciated for tax
purposes and could be sold today for £30,000. It is anticipated that after using it for another five years the
equipment will have no second-hand value. The production would take place in the company's main factory.
However, the company will have to relocate the production of another product to make space available. This will
require renting some additional accommodation at a cost of £20,000 per annum. It will also be necessary to invest
£15,000 in additional working capital. The tax rate is 30 per cent. The discount rate for this project is 14 per cent.
Use four investment appraisal techniques to determine whether you should go ahead with the project. I need you to help me to identify also what a manager would do in this situation what are the issues/problems presented in the problem