Hi,

Just wondering if anyone could help me with this question, its for uni and I just cannot get my head around it, any help would be much appreciated!

A pharmaceutical company, is currently (at 1 January 2007) considering an investment in a new product, which is similar to the company’s existing product range. The investment would involve the following costs and revenues:
(I) An immediate purchase of capital equipment costing €/£ 2 million would be required. This equipment is expected to have a residual value in four years of €/£ 200,000, and will be depreciated at 25% per annum on a straight line basis. Capital allowances can be claimed at 25% per annum on a reducing balance basis.

(ii) Sales of the new product will be €/£ 2.5 million per annum for four years. Breakthrough Limited earns a contribution of 50% on sales.

(iii) The new product would require that a stores manager be recruited at a cost of €/£ 60,000 per annum. However, there is an 80% probability that a manager who is due to retire would be interested in taking up the position, at an annual salary of €/£ 40,000. If he retires, the company will have to make annual contributions of €/£ 15,000 to fund his pension.

(iv) The new product will require an investment of €/£ 361,000 in working capital. This should be assumed to arise on 1 January 2007.

(v) Annual fixed overheads relating to the new product are estimated at €/£ 100,000, and in addition there will be allocated annual fixed overheads of €/£ 40,000.

(vi) Research and development costs of €/£ 200,000 have been incurred, and a further €/£ 150,000 have been contracted for.

Requirement:
(a) Indicate whether Breakthrough Limited should proceed with the new product, using NPV.
(b) Compute the payback period.

(c) Calculate the accounting rate of return (after tax).

Assumptions:
You should assume a corporation tax rate of 12.5%. The tax liability is payable one year in arrears.
The applicable cost of finance (after tax) to be used for discounting is 11%.

And what do you think ?

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