Khan Ltd is an importer of novelty products. The directors are considering whether to introduce a new product, expected to have a very short economic life. Two alternative methods of promoting the new product are available, details of which are as follows:
Alternative 1 would involve heavy initial advertising and the employment of a large number of agents. The directors expect that an immediate cash outflow of £100 000 would be required (the cost of advertising) which would produce a net cash inflow after one year of £255 000. Agents’ commission, amounting to £157 500, would have to be paid at the end of two years.
Alternative 2 would involve a lower outlay on advertising (£50 000, payable immediately), and no use of agents. It would produce net cash inflows of zero after one year and £42 000 at the end of each of the subsequent two years. Mr Court, a director of Khan Ltd, comments, ‘I generally favour the payback method for choosing between investment alternatives such as these. However, I am worried that the advertising expenditure under the second alternative will reduce our reported profit next year by an amount not compensated by any net revenues from sale of the product in that year. For that reason I do not think we should even consider the second alternative.’ The cost of capital of Khan Ltd is 20 per cent per annum. The directors do not expect capital or any other resource to be in short supply during the next three years. You are required to: (a) calculate the net present values and estimate the internal rates of return of the two methods of promoting the new product; (10 marks) (b) advise the directors of Khan Ltd which, if either, method of promotion they should adopt, explaining the reasons for your advice and noting any additional information you think would be helpful in making the decision; (c) comment on the views expressed by Mr Court. Ignore taxation. (8 marks) (7 marks)