London Sweets plc is considering introducing a new range of cakes, the “Lemon-Lime cheesecake”, to complement their existing product line. The company is wholesaler and sells the products in boxes (hereafter referred to as units). To decide whether to proceed with this project, the company has commissioned a report from a consultant. The consultant has identified the following likely outcomes if they choose to go ahead:
• Sales of "Lemon-Lime" cheesecakes are likely to be 400,000 units in the first year and will increase by 5 percent per year each year until a new range will be needed to replace them at the end of 4 years.
• As a result of selling the new cake the company expects a large increase in the sales of their existing tea range (“The Tea”) by an additional 20,000 units in the first year of the project. From year 2, the sales increase will be 250% of the previous year’s increase.
• After market research which cost the firm £55,000, a selling price of £6 per unit has been agreed.
• The cost of ingredients to make the cakes is likely to be £2.50 per unit with other variable costs of production likely to come to £0.50 per unit.
• “The Tea” currently has a selling price of £1.50 per unit and variable costs of production of £0.50 per unit.
• An issue of concern is that selling the cheesecakes will reduce sales of the company’s existing traditional “New Yorksher” cheesecake. The consultant estimates that sale of “New Yorksher” could go down 250,000 units in the first year, and this figure will increase by 30% in year 2 & again in year 3 before reaching a new equilibrium. The “New Yorksher” sells for £4 per unit and has a variable cost of production of £2 per unit.
• To produce the new cake, a machine costing £980,000 will be acquired. This value will be depreciated on a straight-line basis to zero salvage value over the 4 years of the project, and it is expected to be sold for £25,000 at that time.
• To market the cakes the company intends to use an unused office which they bought 10 years ago for £100,000. The asset could be sold today at its after-tax market value of £150,000. The after-tax market value of the office is not expected to change over the term of the project.
• The company will invest £30,000 in working capital to cover the need for raw materials inventory at the start of the project which will be refunded at the end of the project.
• The company currently has fixed costs of £200,000 and these are expected to increase to £300,000 per year if the new cake is produced.
• Corporate taxes are 30% and are paid immediately during the year in which they are incurred.

Project approval at London Sweets Plc
For this type of project London Sweets Plc requires that three hurdles be met:
• The project has a net present value (NPV) of at least £1.2m using the cost of capital of 12%;
• The project has an internal rate of return greater than 20%; and
The project has a payback period of 3 years or less.

Required:
a. Using all relevant cash flows set up the capital budget and compute the NPV, IRR, and payback of the project. Advise the firm as to whether it should go ahead with the project in light of the investment appraisal criteria outlined above.
b. There is a concern about whether the new product is priced correctly. Consultants have suggested two likely scenarios – (i) raising the price to £6.50 per unit, which would limit the growth rate of sales to 1 percent per year and (ii) lowering the price to £5.25 per unit, which would increase the sales growth rate to 7.5 percent per year. Carry out a sensitivity analysis of the impact of these externalities on the NPV of the overall project. If either of these scenarios result in a higher NPV than the existing price structure, you should adopt that price and growth rate for the remainder of the assignment.
c. Consultants have noted that the effect of the new product on the sales of the “New Yorksher” is significant and suggest examining the possibility of altering the price of the older product to mitigate these effects, taking into account the fact that a higher price could restrict sales growth while a lower price may encourage it. To begin with they suggest that the rate for change in sales for “New Yorksher” not be a fixed 30% but instead be calculated such that for every 10p drop in price compared to the original, the drop in sales would be 1% less. For example, while the original £4.00 gives a 30% drop, £3.90 would give a 29% drop, and a £3.50 price would give a 25% drop. Once that change is implemented, you should use the solver to alter the price of the “New Yorksher” to be at least £3.49. Additionally, the marketing department notes that the estimate of additional initial sales of “The Tea” could have been underestimated by as many as 200 units. What is the effect of these changes on the NPV? Discuss the results. Use Excel’s solver facility to advise the company on how it can achieve the desired approval criteria based on the information provided above.
d. Discuss the reasons why traditional NPV analysis tends to underestimate the true value of capital budgeting projects and explain how considering options can improve the reliability of capital budgeting decisions.

London Sweets plc is considering introducing a new range of cakes,...