Accounting & Finance Question 1
Game Co has developed a new computer game called ?Loomcraft?. ?2.4m has been spent developing the game over the last year. A market research company has now completed research on behalf of Game Co and has identified the following sales price and volumes for the life of the game:
Sales price Sales volume
Year 1 ?35 120,000
Year 2 ?35 360,000
Year 3 ?28 560,000
Year 4 ?28 480,000
Year 5 ?25 350,000
After the end of the 5th year sales are expected to cease altogether.
The cost of the market research was ?250,000 and is due for immediate payment.
Production would require the purchase of new technology costing ?4m (payable immediately). This technology would then have to be updated at the end of the second and fourth years at a cost of ?1,200,000 each time. ?4.5m would also be spent on capital equipment which would have a scrap value of zero at the end of the project. Half of this amount would be payable immediately and the other half in one year?s time. It is Game Co?s policy to depreciate all assets over their useful economic life on a straight line basis.
Production would give rise to an immediate additional working capital requirement of ?2m which would be released again at the end of production in year 5.
The variable production cost of producing each copy of Loomcraft would be ?6. Game Co would also need to rent additional business premises at a cost of ?2.3m each year, payable in advance each year. Other fixed costs of ?3.4m per annum are forecast, ?1m of which represent the Loomcraft project?s share of general overheads.
The company's cost of capital is 10% pa.
When payback is used the company?s policy is to accept all projects with a payback period of less than four years.
Assume that operating cash flows occur at the end of the year to which they relate.
Ignore the effect of taxation.
(a) Calculate the net present value (NPV) of the project to manufacture Loomcraft and recommend, on the basis of this calculation, whether Game Co should proceed with the project. All workings should be to the nearest ??000.
(b) Explain what the term ?relevant cash flow? means and explain which of Loomcraft?s costs are not relevant to the project and have therefore been excluded from your calculations in part (a).
(c) Calculate the internal rate of return of the project to the nearest whole percentage point.
(d) Calculate the project's payback period to the nearest month and recommend whether Game Co should accept the project.
(e) Discuss the relative advantages and disadvantages of using payback period to appraise a project as opposed to using IRR or NPV.
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