Management Accounting $3($Module $2)$ Year$-$end SUPP. Examination $2013$

Question $2$

Novak Industries $($Pty$)$ Ltd is a successful Durban$-$based manufacturer of tennis

$(25$ Marks$)$ balls. However, over the past few years, Novak's directors noticed that demand for tennis balls in the Durban area is declining, whilst the hype surrounding the $2011$ operations by producing cricket balls. balls. Therefore, they

Novak Industries $($Pty$)$ Ltd has incurred a cost of R$50000$ to employ a consultant to estimate expected cash flows resulting from the potential cricket ball project. Her findings are presented below.

Sales of cricket balls for the next year are expected to be $10000$ units, increasing by $5\%$ per year for the next two years. However, in the fourth year, sales will start to decline by $3\%,$ and as a result, the firm will terminate the project after four years. The selling price will be R$100$ per cricket ball in the first year and increase at $8\%$ per year for the life of the project.

Variable costs are expected to amount to R$40$ per unit in the first year and rise by $11\%$ per year.

The initial cost of the new machine required to produce the cricket balls is R$1\mathrm{.}5$ million, which will be depreciated using the straight line method over five years to zero. At the end of the project, the machine will be sold for R$500000.$ The cricket ball machine will also increase pre$-$tax distribution costs for the company by R$65000$ per year.

The introduction of the new cricket ball machine will require an immediate increase of R$50000$ in net working capital. Only $80\%$ of this amount will be recovered at the end of year $4.$ In order to make room for the new machine, Novak Industries $($Pty$)$ Ltd will have to decrease their production of tennis balls, resulting in pre$-$tax profit of R$20000$ per year for the duration of the cricket ball project.

Additional useful information:

The corporate tax rate is $30\%$ and the required rate of return is $10\%.$

REQUIRED:

Present an Net Present Value $($NPV$)$ analysis to the directors of Novak Industries in order to advise them whether or not the firm should undertake the project to produce cricket balls.

$(16$ marks$)$

Also, use the Pay Back period to support your answer.

$(5$ marks$)$

Why are NPV and Internal Rate of Return $($IRR$)$ preferred to other capital budgeting appraisal methods?

$(4$ marks$)$