Wivenhoe Ltd wants to expand its market and is considering two mutually exclusive projects as follows:
Project A: This project requires an initial investment of £178,000 with a four-year life span. Wivenhoe Ltd has already paid £20,000 to a market research company. Forecasted sales and operating expenses are shown in the table below:
Year 1 Year 2 Year 3 Year 4
Sales revenue (£) 260,000 290,000 300,000 280,000
Material cost (£) 100,000 120,000 115,000 118,000
Labour cost (£) 60,000 72,000 52,000 66,000
Other fixed cost (not including depreciation) 10,000 10,000 18,000 18,000
Project B: This project requires an initial investment of £480,000 with a four-year life span. The forecasted annual accounting profit is £80,000 over four years.
The following information applies to both projects:
• Residual value at the end of the economic life of each project is nil, and straight line depreciation applies.
• All sales are expected to be cash sales, and operation expenses are paid for in cash as and when incurred.
• Depreciation is the only adjustment difference between accounting profit and cash flows for each project.
Required:
(a) What is meant by ‘mutually exclusive projects’?[3 marks]
(b) Wivenhoe Ltd’s managers sought your advice regarding which of the projects to select.
(i) Calculate for each project the payback period (Assume that cash flows will occur evenly throughout the year).[5 marks]
(ii) Advise Wivenhoe Ltd’s managers as which project to select in (b) (i) above.[1 mark]
(c) For Project A: calculate the breakeven point in sales revenue for year 4.[5 marks]
(d)
(i) Calculate the NPV of Project A using a cost of capital of 9%. (Assume that all cash flows occur at the year-end).[5 marks]
(ii) Comment on the viability of the project.[1 mark]
(e) Calculate the unit cost under marginal costing and absorption costing for the second year of project A. 5,000 units of the product are expected to be produced and sold. [5 marks]