Tag (SQ): product replacement

A well-established company in the region of the Volta River manufactures engines. One of its current products is Product X, for which sales will be 150,000 units in the year just ending (Year 1). However, after four more years, at the end of Year 5, Product X will no longer be permitted, when new government environmental regulations come into force. On or before that time, the company needs to introduce a new product to replace Product X.
A replacement product has already been developed. This is Product Y. A market research report has estimated that, if Product Y is introduced to the market now to replace Product X, annual sales of Product Y at a unit price of GH₵350 would be:

The current selling price of Product X is GH₵250 per unit, and its variable cost of sales is GH₵180. There is no possibility of increasing the selling price.
The annual sales demand for Product X is expected to fall each year if it is kept on the market. The best estimate is that annual sales in Year 2 will be 10,000 units less than in Year 1, with a further fall in sales by 10,000 units each year until Year 5.
To prepare a production facility for manufacturing Product Y instead of Product X, an initial capital outlay of GH₵2,000,000 would be required. Annual fixed costs would increase by GH₵160,000. The variable cost of making and selling Product Y would be GH₵230 per unit.
The company’s cost of capital is 8%. Ignore inflation and taxation.

Required:
(a) Using DCF analysis, calculate the NPV of a proposal to replace Product X with Product Y from Year 2 onwards.

(b) Estimate the minimum annual sales for Product Y that would be required to justify the immediate replacement of Product X with Product Y. Assume that the estimates of annual sales of Product X are correct.

(c) Calculate the minimum reduction in the annual sales of Product X, in Year 2 and in each subsequent year that would be necessary before you recommended the immediate replacement of Product X with Product Y. Assume that the estimates of annual sales of Product Y are correct.

(d) List briefly the weaknesses or limitations in the financial analysis in part (a) to (c) above.