Fine Chemicals plc

Fine Chemicals plc has recently received an invitation to produce a new chemical for
supply to a textile manufacturer. The invitation is to produce 15,000 kg each year for the
next three years at a price of 42 a kg.

The following information has been collected which will help the directors to reach a
decision on whether to accept the invitation or not:

New plant costing 200,000 will need to be bought and paid for at the start of
production. This will have a residual value of 10,000 at the end of the third year. If the
plant is acquired, the business will follow its normal practice of depreciating it on a
straight-line basis in the annual financial accounts.

Ten new workers will be taken on for the duration of production. Recruitment costs,
payable at the start of the production period will total 20,000. The workers will be paid
compensation for being made redundant at the rate of 3,000 per worker, payable at the
end of the production period. During the production period the workers will be paid
200,000 in total each year.

Production of the new chemical will be charged with a share of the businesss
overheads totalling 55,000 in each of the three years. It is estimated that the production
of the new chemical will give rise to an increase of 18,000 in overheads.

Production will require the use of an ingredient, known as X15G, at the rate of 6,000 kg
each year. The business already has inventories of 4,000 kg. This was originally bought
for 15 per kg. This was bought for a previous contract that had to be abandoned. If the
inventories of X15G are not used in production of the new chemical there is no other
use for it and it will be disposed of immediately. It will cost 2 per kg to dispose of the
X15G. The cost of new X15G is 20 per kg.

Production will also require the use of 9,000 kg each year of another ingredient, known
as Y23D. The business already has 9,000 kg in inventories, which cost 25 per kg.
Recently the buying price has dropped to 20 per kg. The business could sell its
inventories of Y23D for 15 per kg. Y23D is used in large quantities on a number of the
businesss current products.

Assessing the investment in the plant is to be undertaken on the basis of a finance cost
of 12% each year.

The above data were discovered by a consultant who is to be paid a total of 2,000 for
the work.

Treat cash flows relating to revenue, overheads, inventories purchases and labour as
occurring at the end of the relevant year.

Required:
Produce calculations which show, on the basis of net present value, whether the new
chemical should be produced or not and state your conclusion.