Rabbit Inc. is considering the production of Product X and Y.

Product X

It can only be produced on a new machine, which has an expected cost of $200,000 and a four-year life span. The annual cash savings are expected to be $50,000 in the first year, rising at 20% per annum thereafter until the end of the production. The new machine will attract a capital allowance of 25% on the written down value of the machine in each year. The company can claim any unrelieved capital allowance at the end of the production.

Product Y

Production of Product Y is expected to last for three years. Sales are expected to be 1,000 units in the first year, 1,200 units in the second year, and 800 units in the third year. Each unit can be sold for $20.

It can be produced on an existing machine which has been idle for some time. This existing machine can be sold immediately for $10,000. If the production does go ahead, a one-off modification on the machine will be needed at a cost of $15,000 payable at the beginning of the first year.

Each unit of Product Y requires 1 kg of material at $4 per kg and one hour of skilled labour at $4 per hour. These costs are expected to rise in line with inflation.

The company has a choice to defer the production of Product Y until the beginning of the second year. If the company defers this production, the first year sales contribution will be lost irrevocably.

The company also has an option to purchase a brand new machine for the production of Product Y. It will cost the company $50,000 now or $30,000 in one year’s time. This machine does not qualify for capital allowance.

The company’s policy is to depreciate machines over their useful economic life on a straight-line basis. No machine is expected to have any value at the end of its life.

The inflation rate is expected to be 5% per annum. The company’s after-tax cost of capital is 10% per annum. Corporate tax rate is 30%, payable one year in arrears. Apart from the cash flows mentioned above, the company can raise an additional fund of $190,000 only at the beginning of year 1. There is no capital restriction in subsequent years.

Required:

Advise Rabbit Inc. of the best investment plan in the above situations.

Answer rating: 100% (QA)

Based on the given information Rabbit Inc is considering the production of two products X and Y Lets evaluate the investment plan and determine the be... View the full answer