On 31 December year 0, Khan Lt

On 31 December year 0, Khan Ltd invested in some machinery andstarted to manufacture a new product the ‘gadget’. The decision wasbased on the machinery being capable of producing gadgets until theend of Year 6 and sales continuing until that time.

Actual sales of gadgets have not been as buoyant as projectedwhen the investment was being appraised during year 0. As a result,the business’s management is considering abandoning the project atthe end of year 3, earliest date at which it would be feasible todo so. You have been asked to prepare calculations and recommendwhether to abandon the project at that time or to continue asoriginally projected until the end of year 6.

You have discovered the following :

1. The machinery was bought on 31 December year 0 for £420,000.Where production to be abandoned at the end of year 3. Should theproject continue, the machinery would be disposed of in lateDecember year 6, for zero proceeds.

Depreciation of this machinery has been, and if retained willcontinue to be, charged at the rate of £70,000 a year.

2. It has been estimated that the most likely sales levels for theremaining three years of the project will be as follows:

                                                                                               Numberofgadgets         

                            Year4                                                              2,400

                            Year5                                                            2,400

                            Year 6                                                             1,500

3. Gadgets are sold for £200 each. This produces a contribution of£80 a gadget.

4. The variable costs include £90 a gadget for materials. The onlyother element of variable operating cost is labour.

5. The business also has a longstanding product, the ‘widget’, forwhich the market is very buoyant. This uses the same manufacturinglabour, paid at the same rate, as the gadgets. As a result of ashortage of this labour, sales of widgets are lost when gadgets areproduced. A higher-than-planned output of widgets has occurredsince Year 1, due to the labour released by the gadget salesshortfalls

6. It is believed that there are no other relevant cash flowsassociated with the decision.

7. Given the risk of the project, a cost of capital of 15% peryear is considered appropriate.

8. Assume that all operating cash flows arise on the last day ofthe accounting year concerned.

Required:

Show calculations that indicate, on the basis of net presentvalue at 31 December Year 3, whether Khan Ltd should abandon gadgetproduction at the end of Year 3 or continue until Year 6.