Option 1
Gaea will consider ending the production and sales of Dreams ice cream and replace it with its new Heat ice cream line. Heat ice cream is an innovative ice cream that does not melt in room temperature and has been developed by the Gaea’s research and development department over the last year. The research and development of the Heat ice cream has already cost£32,500, of which £10,000 has yet to be paid by 31 December 2020.The sales of Heat ice cream are expected to last 5 years and the marketing department has estimated the following salesfor the five-yearperiod from2021to 2025:
Table 1
Estimated sales of Heat ice cream for period from 2021 to 2025YearSalesof Heat ice cream(in kg)202112,000202218,000202324,000202418,000202512,000The selling price is £11.50 per kg; the variable cost is £4.50 per kg and the incremental fixed costs £30,000 per year.Option 2Gaea will introduce the new Heat ice cream but will also retain the current Dream ice cream aimedat the lower price market. The Dream’s icecream sales will be retained for 3 years, selling at £9.6 per kg and at the quantities shown in Table 2.
Table 2
Dream’sice cream sales across 3 yearsYearSales of Dream ice cream (in kg)20214,80020223,60020232,400
However, the retention and sales of Dreams ice cream for three years will reduce the sales of the new Heat ice cream over this period by one kg of Heat for every two kg of Dream.The Dream ice cream has an estimated variable cost of £5.50 per kg and associated incremental fixed costs £2,000 per year.The machinery currently used for the production of Dreams ice cream will continue to be in place for a number of years, has zero written-down value and zero market value.If the Heat ice cream is introduced, new machinery should be bought for £150,000. The machine is available and can be purchased, paid in cash now and be used for immediate production at the start of the accounting year 2021. The machine is expected to operate for the five years period, 2021-25, that Heat ice cream will be produced and then be scrapped with zero market value.If Gaea Ltd decides to cease production of Dreams and replace it with Heat, there will be redundancy payments of £14,400 to the production staff on 31 December 2020.If the company approves option 2 and decides to introduce Heat and retain Dreams for 3 years, the redundancy payments will be as follows:
Table 3
Redundancy payments if the company approves option 2YearRedundancy payments (£)2020 (31 Dec, i.e., t=0)6,0002021(31 Dec, i.e., t=1)4,8002022(31 Dec, i.e., t=2)4,8002023(31 Dec, i.e., t=3)2,400All redundancy payments are tax-reducing expenses and will attract corporate tax relief.The operations manager has informed you of the need for working capital, which is 10% of the following-year’s sales and has to be in place at the start of each accounting year. Currently, there is no such working capital in place. The working capital will be reduced to zero at the end of the five-year investment period and has no tax implications. The corporate tax rate is 20% and is expected to remain unchanged over the period of the investment. The new machinery will attract full capital allowances at 25% per year on reducing balance basis. At the end of the five-year period, 31 December 2025,a balancing charge or allowance will arise on disposal of the new machinery.
Required:
(a)Estimate the Net Present Value of both options, showing clearly all your calculations.(50marks)(b)Estimate the Internal Rate of Return of both options, showing clearly all your calculations.(10marks)(c)Estimate the sensitivity of the NPV to the price of the selling price of Heat ice cream only, for both options.(20marks)
