The produce development department of Braithwaite plc is contemplating renting a factory building on a five-year lease from 31 December 2010, investing in some new plant and using it to produce a new product, code named BB8. Since there appears to be no possibility of the plant continuing to be economically viable beyond a five-year life, it has been decided to assess the new product over a five-year manufacturing and sales life. Under the lease the business will pay £550,000 annually in advance on 31 December starting 31 December 2010. The plant is expected to cost £2,500,000. This will be bought and paid for on 31 December 2010 and is expected to be scrapped (zero proceeds) on 31 December 2015. The business will depreciate this asset, in the accounts, on a straight-line basis (20% each year). Each unit of BB8 is estimated to give rise to a variable labour cost of £375 and a variable material cost of £250. BB8 manufacture will be charged with an annual share of the business’s administrative costs, totalling £360,000 each year. Manufacture and sales of BB8’s is expected to increase total administrative costs by £240,000 each year. Manufacture and sales of BB8’s are expected as follows: Year ending 31 December YEAR units of BB8 2011 800 2012 950 2013 1250 2014 900 2015 600 These will be sold for an estimated £4,500 each. The business’s accounting year-end is 31 December each year. It has been decided given the level of risk involved with the project to use a discount rate of 8% a year. Required: Estimate and compute the internal rate of return of the project.
The produce development department of Braithwaite plc is contemplating renting a factory building on a five-year lease from 31 December 2010, investing in some new plant and using it to produce a new product, code named BB8.
Since there appears to be no possibility of the plant continuing to be economically viable beyond a five-year life, it has been decided to assess the new product over a five-year manufacturing and sales life.
Under the lease the business will pay £550,000 annually in advance on 31 December starting 31 December 2010.
The plant is expected to cost £2,500,000. This will be bought and paid for on 31 December 2010 and is expected to be scrapped (zero proceeds) on 31 December 2015. The business will
Each unit of BB8 is estimated to give rise to a variable labour cost of £375 and a variable material cost of £250. BB8 manufacture will be charged with an annual share of the business’s administrative costs, totalling £360,000 each year. Manufacture and sales of BB8’s is expected to increase total administrative costs by £240,000 each year.
Manufacture and sales of BB8’s are expected as follows:
|
Year ending 31 December |
YEAR | units of BB8 |
| 2011 | 800 | |
| 2012 | 950 | |
| 2013 | 1250 | |
| 2014 | 900 | |
| 2015 | 600 | |
These will be sold for an estimated £4,500 each.
The business’s accounting year-end is 31 December each year.
It has been decided given the level of risk involved with the project to use a discount rate of 8% a year.
Required:
Estimate and compute the
Capital budgeting is the process by which a corporation examines potential large projects or investments. Before a project, such as the construction of a new facility or a big investment in an outside business, is approved or denied, capital budgeting is essential.
Internal Rate of return
It is the rate of return at which the Net present value of the project is NIL or the difference between the present value of cash outflows and cash inflows are zero.
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