Question

New Age Electronics Ltd is a business that is engaged in research focusing on wireless communication technologies. The company recently developed a new set of wireless head phones that work on the frequency modulation (FM) signal and is currently considering whether or not to go for mass production. The Board of Directors will soon meet to make a final decision and has the following information available to help it decide: • The cost of developing the headphones has been N$1 750 000 to date and the company is committed to spending a further NS500 000 within the next two months Irrespective of whether the head phones are produced and sold or not. • The company has spare production capacity and can produce the head phones using machinery that will cost N$5 800 000 and which will be purchased immediately. It is expected to be sold at the end of four years for N$1 000 000 • Total fixed costs identified with the production of the headphones are N$2 000 000 per year. This includes a depreciation charge in respect of the machinery of N$1 200 000 per year and a charge allocated to represent a fair share of the fixed costs of the business as a whole of N$350 000 per year. • The headphones are expected to sell for N$1 200 each and the marketing department believes that the business can sell 10 000 head phones per year over the next four years. • The variable costs of production are N$800 per head phone. . If the business decides not to produce the head phones it can sell the patents immediately for N$1 600 000 • The company has a cost of capital of 12%. Ignore taxation and inflation. REQUIRED: Marks 1.1. Calculate the net present value (NPV) of producing and selling the new head phones rather than the alternative of selling the patent Clearly indicate with a suitable motivation any costs not taken into account in your appraisal. 1.2. Carry out a separate sensitivity analysis to show by how much the following factors would have to change before the proposal to produce and sell the new headphones has an NPV of zero: a) The initial outlay on the machinery b) The discount rate TOTAL MARKS

Answer 1

		1st yr	2nd Yr	3rd Yr	4th Yr
Sales		12000000	12000000	12000000	12000000
Fixed Cost		2000000	2000000	2000000	2000000
Variable Cost		8000000	8000000	8000000	8000000
Total Cost		10000000	10000000	10000000	10000000
Profit		2000000	2000000	2000000	2000000
Add Depreceiation		1200000	1200000	1200000
CFAT		3200000	3200000	3200000	2000000
Particulars	Year	Amount	PV Factor0.12	Total PV
Cash Outflow	t=0	-8050000	1.000	-8050000
Operating CFAT	1	3200000	0.893	2857600
Operating CFAT	2	3200000	0.797	2550400
Operating CFAT	3	3200000	0.712	2278400
Operating CFAT	4	2000000	0.636	1272000
Salvage Value	4	1000000	0.636	636000
NPV				1544400
Immediate sale of patent				1600000

Sale of Patent is more profitable