BUSF_A01.qxd

Chapter 5 • Practical aspects of investment appraisal

Kitchen Appliances plc

Kitchen Appliances plc is assessing an investment project that involves the production and

marketing of a sophisticated household food mixer, the Rapido. The annual sales volume is

expected to run at 10,000 Rapidos for five years.

The development department has produced the following estimate of annual profit from

the project:

£000

Sales revenue 2,000

Raw materials 600

Labour 600

Depreciation 240

Rent 60

Overheads 200

Interest 100

1,800

Annual profit before taxation 200

The following additional information is relevant:

1 The production will require the purchase of a new machine at a cost of £1,200,000,

payable on delivery. The machine will be depreciated on a straight line basis over the five

years. It is not expected to have any second-hand value at the end of that time.

2 Production of Rapidos will take place in a building currently used for storage. Apportioning

the rent of the entire site occupied by the business on the basis of area, the building has

a rental cost of £60,000. If production goes ahead, the business can rent a small warehouse,

which will be adequate for storage purposes, for £10,000 p.a. payable annually in arrears.

If Rapido production is not undertaken there are plans to sublet the building to

another business at a rent of £40,000 p.a. payable annually in arrears and to rent the

small warehouse for £10,000 p.a.

3 £36,000 has been spent on developing the Rapido and a further £10,000 on a market

survey to assess demand.

4 The overheads of £200,000 p.a. represent an apportionment of the overheads of the entire

business on the basis of labour hours. The operating overheads will be increased by

£90,000 p.a. as a result of Rapido manufacture. This includes £30,000 p.a. salary to a man-

ager who is due to retire immediately on a pension of £10,000 p.a. If Rapido manufacture

goes ahead, the manager will not retire for another five years. Staying on for the addi-

tional period will not affect the pension that the manager will ultimately receive. Pensions

are paid by the business and the amounts are charged to non-operating overheads.

The remaining £60,000 represents salaries payable to two managers who will be taken

on for the duration of the project, should it go ahead.

5 If Rapidos come on to the market there is expected to be a reduction in anticipated

demand for the existing food mixer, the Whizzo, which the business also manufactures.

The reduction in the volume of Whizzo sales would be expected to be:

Year Units

1 10,000

2 10,000

3 5,000

4 5,000

5 5,000

Example 5.5