Variable cost

Question 1

Nakami Limited is evaluating whether or not to produce a new line of portable wireless

speakers. If the firm decides to embark on this project, it needs to invest $3.2 million on

production equipment.

The forecasted selling price is $100 per unit and this will increase in line with general

inflation of 3% per year. Forecasted sales and production have been estimated as follows:

Year 1 2 3 4

Sales and production (units) 27,000 30,000 35,000 25,000

Due to rapid advancement in technology of audio products, the operations will cease at the

end of four years.

Variable costs are about 60% of selling price. Incremental overheads, which includes

primarily rental, is estimated to be $200,000 per year. Net working capital amounting 15% of

sales is required at the beginning of each year. This will be fully recovered when the

operations cease and scrap value of equipment is about 5% of its cost.

Depreciation is computed on a straight-line basis over the four-years. The rate of corporation

tax is 17%. Nakami has traditionally used a discount rate of 11% per year for investment

appraisal.

(a) Calculate the accounting break-even and cash break-even for each of the four (4)

years.

(10 marks)

(b) Calculate the NPV break-even for this investment opportunity.

Hint: The number of units sold must be same in each of the four years.

(8 marks)

(c) Calculate the degree of operating leverage (DOL) for the first year of operations.

Using the DOL you have computed, determine the net operating income (or EBIT) if

sales increase by 10%.

(6 marks)

FIN309 Assignment 2

SIM UNIVERSITY Assignment 2 – Page 3 of 5

(d) Since it is a new product, Nakami is not sure about the forecast. On further research,

the marketing department has made the following demands in units forecasts based on

the probability.

Probability Year 1 Year 2 Year 3 Year 4

0.5 22,000 25,000 30,000 20,000

0.5 32,000 35,000 40,000 30,000

Expected 27,000 30,000 35,000 25,000

The probabilities are for the series of demand in units.

Given this refinement in forecast, discuss the strategies Nakami can follow in relation

to this project. Assume that the company will install a capacity of 27,000 units based

on the expected demand in units at the current time.

(8 marks)

Question 2

The latest available financials of Nakami Limited is shown below:

Statement of Profit or Loss Statement of Financial Position

For the year ended 31 Dec 2015 As at 31 Dec 2015

$’000 $’000

Revenue * 12,790 Current assets

Cost of sales # (3,438) Cash and bank balances 3,534

Gross profit 9,352 Trade receivables 3,266

Operating expenses (1,456) Inventories 843

Profit before income tax 7,896 7,643

Income tax expense (1,357)

Profit for the year 6,539 Non-current assets

Plant and equipment 3,214

* All on credit terms. Total assets 10,857

# Beginning inventories is $702,000.

Current liabilities

Trade payables 651

Income tax payable 1,349

2,000

Capital and reserves

Share capital 6,000

Retained earnings 2,857

8,857

Total liabilities and equity 10,857

Sharon, the finance director of Nakami is looking to improve the firm’s working capital

management. She is thinking of extending an early settlement discount of either 2/15, net 90

or 1/10 net 60 for all customers. Regardless of which proposal is implemented, the level of

trade receivables is expected to reduce by the same amount.

FIN309 Assignment 2

SIM UNIVERSITY Assignment 2 – Page 4 of 5

(a) Calculate the cash conversion cycle for FY 2015.

(13 marks)

(b) Calculate the cost of implementing the trade credit scheme (in percentage). Analyse which credit terms should Nakami extend to its customers.

(7 marks)

(c) In using percent of sales method of financial planning, it is assumed that all items including working capital items are expected to vary with sales at the same percentage. However, inventory is based on cost of goods sold and payables are based on purchases. Discuss how inventory and payables can be expressed as percent of sales.

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