QUESTION ONE

Trade Kings is preparing to launch a new product in a new market which is outside its current business operations. the company has undertaken market research and test marketing at a cost of $5000,000, as a result of which it expects the new product to be successful. Trade kings plans to charge a lower selling price initially and then increase the selling price on the assumption that the new product will establish itself in the new market. Forecast sales volumes, selling prices and variable costs are as follows:

Year 1 2 3 4

Sales volume (units/year) 200,000 800,000 900,000 400,000

Selling price 15 18 12 22

Variable cost ($/unit) 9 9 9 9

Selling price and variable cost are given here in current price terms before taking account of forecast selling price inflation of 4% per year and variable cost inflation of 5% per year.

Incremental fixed cost of $500,000 per year in current price terms would arise as a result of producing the new product. Fixed cost inflation of 8% per year is expected.

The initial investment cost of production equipment for the new product will be $2.5 million, payable at the start of the first year of operation. Production will increase at the end of four years because the new product is expected to have become obsolete due to new technology.

The production equipment would have a scrap value at the end of four years of $125,000 in future value terms.

Investment in working capital of $1.5 million will be required at the start of the first year of operation. Working capital inflation of 6% per year is expected and working capital will be recover in full at the end of four years.

Trade Kings pays corporation tax of 20% per year, with the tax liability being settled in the year in which it arises. The company can claim tax-allowable depreciation on a 20% reducing balance basis on the initial investment cost, adjusted in the final year of operation for a balancing allowance or charge, Trade Kings currently has a nominal after-tax weighted average cost of capital (WACC) of 12% and a real after=tax WACC of 8.5%.

The company uses its current WACC as the discount rate for all investment projects.

Required:

A). Calculate the Net Present Value NPV of the investment project in nominal terms and comment on its financial acceptability. [15 marks]

B). Critically discuss why Net Present Value (NPV) is regarded as superior to Internal Rate of Return (IRR) as an investment appraisal technique. [10 marks]