Mezen is currently considering the launch of a new product. A market survey was recently commissioned to assess the likely demand for the product and this showed that the product has an expected life of four years. The survey cost $30,000 and this is due for payment in four months' time. On the basis of the survey information as well as internal management accounting information relating to costs, the assistant accountant prepared the following profit forecasts for the product.

Year	1 $'000		2 $'000		3 $'000		4 $'000
Sales	180		200		160		120
Cost of sales	(115)		(140)		(110)		(85)
Gross profit	65		60		50		35
Variable overheads	(27)		(30)		(24)		(18)
Fixed overheads	(25)		(25)		(25)		(25)
Market survey written off	(30)		–		–		–
Net profit/(loss)	(17)		5		1		(8)

These profit forecasts were viewed with disappointment by the directors and there was a general feeling that the new product should not be launched. The Chief Executive pointed out that the product achieved profits in only two years of its four-year life and that over the four-year period as a whole, a net loss was expected. However, before a meeting that had been arranged to decide formally the future of the product, the following additional information became available:

The new product will require the use of an existing machine. This has a written down value of

$80,000 but could be sold for $70,000 immediately if the new product is not launched. If the product is launched, it will be sold at the end of the four-year period for $10,000.

Additional working capital of $20,000 will be required immediately and will be needed over the four-year period. It will be released at the end of the period.

The fixed overheads include a figure of $15,000 per year for depreciation of the machine and

$5,000 per year for the re-allocation of existing overheads of the business. The company has a cost of capital of 10%.

Required

a. Calculate the net present value of the new product. 

b. Calculate the approximate internal rate of return of the product. 

c. Explain, with reasons, whether or not the product should be launched. 

d. Outline the strengths and weaknesses of the internal rate of return method as a basis for investment appraisal.

Answer rating: 100% (QA)

Incremental cash flow All amount 000 Year 1 2 3 4 Total Net profit Loss 17 5 1 8 19 Add Depreciation 15 15 15 15 60 Add Reallocation of overheads 5 5 5 5 20 3 25 21 12 61 Less Working capital 20 20 17 ... View the full answer