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Dallan plc

One of the most successful products of Dallan plc, over recent years, is an electric
motor known commercially as the Powermite. This motor is believed by
management to have only a limited future market and should be superseded by a more
modern one. Such a motor has been developed for the business by an independent
consultancy business at a cost of 300,000, which is due to be paid on 31 December
20X0. A decision now needs to be made on producing and marketing the new motor,
which, if it is marketed, will be sold under the name Dynamotor. The basic proposal
is to cease production and marketing of the Powermite at the end of 20X0 and to
replace it with the Dynamotor.

The directors have agreed to base their decision on a net present value analysis of the
possibilities.

Manufacture of the Dynamotor would take place using new, substantially automated
plant. This plant would cost 1.2 million, payable when the plant would be installed
on 31 December 20X0.

Assuming that the Powermite is phased out at the end of 20X0, sales of the
Dynamotor are expected to be as follows:
units
20X1

10,000

20X2

15,000

20X3

20,000

20X4

15,000

20X5

10,000

A selling price of 100 per unit is expected for the Dynamotor. Variable
manufacturing costs are expected to be 40 per unit and incremental fixed costs
250,000 per annum.

If the Powermite is phased out at the end of 20X0, redundancies among production
staff will take place on 31 December 20X0. The business will make redundancy
payments totalling 120,000, on that date.

Management believes that, if the Dynamotor were not introduced, there would be a
continuing demand for the Powermite until 20X3, assuming an 80 per unit price, as
follows:
units
20X1

4,000

20X2

3,000

20X3

2,000

The Powermite has an estimated 45 per unit variable cost element and has avoidable
(incremental) fixed costs of 70,000 per annum.

Were the Dynamotor not to be introduced, and the Powermite retained, redundancy
payments would be:

At 31 December 20X0

80,000

20X1

30,000

20X2

10,000

Plant currently used in Powermite manufacture is now fairly old and, whenever it
were to be disposed of, would have a market value at, or close to, zero.

The directors estimate that the cost of capital will be 15% per annum for the
foreseeable future.

Required:

Produce calculations that indicate whether the business should introduce the
Dynamotor and discontinue the Powermite or continue Powermite production and not
introduce the Dynamotor.

Comments
The following comments have been made to you:

(a)

The objective of discounting future cash flows in investment appraisal is to correct


for the effects of inflation. Since future rates of inflation are expected to be low, it is
probably not worth bothering to discount any more.

(b)

Net present value (NPV) is a flawed method of investment appraisal because it


completely fails to take account of depreciation of the non-current assets associated
with each project.

(c)

NPV is incapable of helping with investments involving advanced manufacturing


technology, such as computer-aided manufacturing. It is much better to gather
together the data on such investment opportunities and make a more subjective
judgement, based on strategic factors.

Required:

Briefly comment on each of these statements. Your comment should point out, if relevant,
any misunderstanding of the person who made them.