for the purpose of this task you may assume the following 597784

Computation of NPV and tax payable

Sound Equipment Ltd was formed five years ago to manufacture parts for hi-fi equipment. Most of its customers were individuals wanting to assemble their own systems. Recently, however, the company has embarked on a policy of expansion and has been approached by JBZ plc, a multinational manufacturer of consumer electronics. JBZ has offered Sound Equipment Ltd a contract to build an amplifier for its latest consumer product. If accepted, the contract will increase Sound Equipment’s turnover by 20%.

JBZ’s offer is a fixed price contract over three years, although it is possible for Sound Equipment to apply for subsequent contracts. The contract will involve Sound Equipment purchasing a specialist machine for £150 000. Although the machine has a 10-year life, it would be written off over the three years of the initial contract as it can only be used in the manufacture of the amplifier for JBZ.

The production director of Sound Equipment has already prepared a financial appraisal of the proposal. This is reproduced below. With a capital cost of £150 000 and total profits of £60 300, the production director has calculated the return on capital employed as 40.2%. As this is greater than Sound Equipment’s cost of capital of 18%, the production director is recommending that the board accepts the contract.

	Year 1	Year 2	Year 3	Total
	(£)	(£)	(£)
Turnover	180000	180000	180000	540000
Materials	60000	60000	60000	180000
Labour	40000	40000	40000	120000
Depreciation	50000	50000	50000	150000
Pre-tax profit	30000	30000	30000	90000
Corporation tax at 33%	9900	9900	9900	29700
After-tax profit	20100	20100	20100	60300

You are employed as the assistant accountant to Sound Equipment Ltd and report to John Green, the financial director, who asks you to carry out a full financial appraisal of the proposed contract. He feels that the production director’s presentation is inappropriate. He provides you with the following additional information:

• Sound Equipment pays corporation tax at the rate of 33%;
• the machine will qualify for a 25% writing-down allowance on the reducing balance;
• the machine will have no further use other than in manufacturing the amplifier for JBZ;
• on ending the contract with JBZ, any out-standing capital allowances can be claimed as a balancing allowance;
• the company’s cost of capital is 18%;
• the cost of materials and labour is forecast to increase by 5% per annum for years 2 and 3.

John Green reminds you that Sound Equipment operates a just-in-time stock policy and that production will be delivered immediately to JBZ, who will, under the terms of the contract, immediately pay for the deliveries. He also reminds you that suppliers are paid immediately on receipt of goods and that employees are also paid immediately.

Write a report to the financial director. Your report should:

(a) use the net present value technique to identify whether or not the initial three-year contract is worthwhile;

(b) explain your approach to taxation in your appraisal;

(c) identify one other factor to be considered before making a final decision.

Notes:

For the purpose of this task, you may assume the following:

• the machine would be purchased at the beginning of the accounting year;
• there is a one-year delay in paying corporation tax;
• all cashflows other than the purchase of the machine occur at the end of each year;
• Sound Equipment has no other assets on which to claim capital allowances.