Question 4.S-AQ.1: Beacon Chemicals plc is considering buying some equipment to...
Beacon Chemicals plc is considering buying some equipment to produce a chemical named X14. The new equipment’s capital cost is estimated at £100 million. If its purchase is approved now, the equipment can be bought and production can commence by the end of this year. £50 million has already been spent on research and development work.
Estimates of revenues and costs arising from the operation of the new equipment appear below:
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Sales price (£/litre) | 100 | 120 | 120 | 100 | 80 |
| Sales volume (million litres) | 0.8 | 1.0 | 1.2 | 1.0 | 0.8 |
| Variable cost (£/litre) | 50 | 50 | 40 | 30 | 40 |
| Fixed cost (£000) | 30 | 30 | 30 | 30 | 30 |
If the equipment is bought, sales of some existing products will be lost, resulting in a loss of contribution of £15 million a year, over the life of the equipment.
The accountant has informed you that the fixed cost includes depreciation of £20 million a year on the new equipment. It also includes an allocation of £10 million for fixed overheads. A separate study has indicated that if the new equipment were bought, additional overheads, excluding depreciation, arising from producing the chemical would be £8 million a year. Production would require additional working capital of £30 million.
For the purposes of your initial calculations, ignore taxation.
Required:
(a) Deduce the relevant annual cash flows associated with buying the equipment.
(b) Deduce the payback period.
(c) Calculate the net present value using a discount rate of 8 per cent.
(Hint: You should deal with the investment in working capital by treating it as a cash outflow at the start of the project and an inflow at the end.)
The answer to this question can be found at the back of the book on p. 562 .
Beacon Chemicals plc
(a) Relevant cash flows are as follows:
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| £m | £m | £m | £m | £m | £m | |
| Sales revenue | __ | 80 | 120 | 144 | 100 | 64 |
| Loss of contribution | (15) | (15) | (15) | (15) | (15) | |
| Variable cost | (40) | (50) | (48) | (30) | (32) | |
| Fixed cost (Note 1) | \underline{(8)} | \underline{(8)} | \underline{(8)} | \underline{(8)} | \underline{(8)} | |
| Operating cash flows | 17 | 47 | 73 | 47 | 9 | |
| Working capital | (30) | 30 | ||||
| Capital cost | \underline{(100)} | __ | __ | __ | __ | __ |
| Net relevant cash flows | \underline{(130)} | \underline{17} | \underline{47} | \underline{73} | \underline{47} | \underline{39} |
Notes:
1 Only the elements of fixed cost that are incremental to the project (existing only because of the project) are relevant. Depreciation is irrelevant because it is not a cash flow.
2 The research and development cost is irrelevant since it has been spent irrespective of the decision on X14 production.
(b) The payback period is as follows:
| Year 0 | Year 1 | Year 2 | Year 3 | |
| £m | £m | £m | £m | |
| Cumulative cash flows | (130) | (113) | (66) | 7 |
Thus the equipment will have repaid the initial investment by the end of the third year of operations. Therefore, the payback period is three years.
(c) The net present value is as follows:
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| £m | £m | £m | £m | £m | £m | |
| Discount factor | 1.00 | 0.926 | 0.857 | 0.794 | 0.735 | 0.681 |
| Present value | (130) | 15.74 | 40.28 | 57.96 | 34.55 | 26.56 |
| Net present value | \underline{45.09} (that is, the sum of the present values for years 0 to 5) | |||||