RS p.1.c. manufactures domestic food mixers. It is investigating whether or not to accept a three-year contract

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Question:

RS p.1.c. manufactures domestic food mixers. It is investigating whether or not to accept a three-year contract to make a new model for sale through a supermarket chain. The contract uses skilled labour which cannot be increased above that currently available and RS p.1.c. will receive a fixed price of £42 per mixer for all the mixers it can produce in the three-year period. The following estimates have been made:

Capital investment £50000 payable now, with nil scrap value.

Additional overhead £25000 per annum.

Materials £30 per mixer Labour £6 per hour.

The factory manager knows from experience of similar machines that there will be a learning effect for labour. He estimates that this will take the form:

y = ax-0.3

where y = average labour hours per unit

a = labour hours for first unit

x = cumulative production

He estimates that the first mixer will take 10 hours to produce and that the fixed amount of labour available will enable 5000 mixers to be produced in the first year. Apart from the capital investment, all cash flows can be assumed to arise at year ends. The company has a cost of capital of 15%. You are required

(a) to calculate the NPV of the proposed contract

(b) to state what other factors need to be considered before a final decision is made.