Investment Appraisals 3 answer PDF

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ADVANCED INVESTMENT APPRAISAL ANSWERS

Question 1) a) Year £00 Initial investment Scrap value Working capital Cash inflow from operation Tax benefit from capital allowance NET CASH FLOW Discount rate at: 14% PRESENT VALUE NET PRESENT VALUE =

0 -8,000

1

2

3

4

5

-600

-8,600 1,650 1.0000 0.4556 -8,600

3,500 350 3,850

3,000 350 3,350

2,500 350 2,850

1,500 350 1,850

1,000 350 1,350

0.8772

0.7695

0.6750

0.5921

0.5194

3,377

2,578

1,924

1,095

701

£1,826,792 (15 marks)

b)

IRR is appealing because it generates a percentage measure of project value which is preferred by many managers, as their targets are expressed in similar ways. Conversely they feel uncomfortable with an absolute NPV value which has little direct meaning to them. In addition the IRR can be operated without prior knowledge of the required return. NPV regarded as the optimal method of project appraisal, partly because IRR has major flaws:  

It can generate multiple solution values when multiple sign changes occurs in the cash flow profile It may rank project differently from NPV leading to sub-optimal selection in the case of mutually exclusive projects. (5 marks)

Question 2

The Board of Directors of ABC Ltd. a subsidiary of XYZ Ltd. have been worried for some time about their manufacturing equipment in their production units and they have decided that these need to be replaced. Estimates have been arranged with companies and the following has been received concerning the equipment in Unit 13 of the Carham Industrial Estate:-

6 200 600 500 350

752

Firm: Year

Murray (£000)

Perry (£000)

Wade (£000)

Jones (£000)

0

(100)

(150)

(175)

(200)

1

25

50

50

70

2

22

40

50

60

3

20

40

40

60

4

15

20

40

30

5

16

10

40

20

At the end of the project, the equipment will be sold and replaced with the following being received (£000s):Murray Perry Wade Jones

20 5 15 10

You are required to: In report format, explain to the Board of ABC Ltd. which project they should be endorsing. Your report should show full calculations of relevant data and should include the net present value (NPV and IRR) for the above projects. In your advice, include any risk issues that you think are relevant. The company can borrow at 7% per annum.

(20 marks)

Report for the Board of Directors of ABC Ltd. Executive Summary This report will determine which of the machine suppliers products offers the fastest payback period on the investment, the Net present value and the Internal Rate of Return. Introduction

There has, for sometime been concerns regarding the productivity of the machinery used by the joinery company ABC Ltd. The company’s existing equipment has been in use for almost a decade, is relatively inefficient and has become out-dated and obsolete. Given recent developments in machine technology, modern joinery machinery offers far more energy efficiency, greater productivity and will improve safety and the human condition of the workforce. This in turn will contribute to the running of a more profitable business model. It has therefore been concluded that the current machinery stock will need to be replaced subject to the evaluation of the following offers. Discussion Once relevant suppliers were contacted, management received the following tenders:Firm: Year

Murray (£000)

Perry (£000)

Wade (£000)

Jones (£000)

0 1 2 3 4 5

(100) 25 22 20 15 16

(150) 50 40 40 20 10

(175) 50 50 40 40 40

(200) 70 60 60 30 20

The following discussion aims to present a feasibility study of the above offers to determine the best and most economical proposal for the replacement of existing machinery for the benefit of the board of directors. The machinery offered by the suppliers shown, all have individual cost structures offering different levels of savings to the company. The following table shows the net present value of the expected cash savings made from the equipment offered by each seller, the internal rate of return of each machine type, and the payback period of each of the machineries.

Firm/Year

Murray Perry Wade Jones Cumulative Cumulative Cumulative Cumulative Cash Cash Cash Cash Cash Cash Cash Cash Flows Flows Flows Flows Flows Flows Flows Flows

0 1 2 3 4 5 NPV IRR

(100.00) (100.00) (150.00) (150.00) (175.00) (175.00) (200.00) (200.00) 25.00 (75.00) 50.00 (100.00) 50.00 (125.00) 70.00 (130.00) 22.00 (53.00) 40.00 (60.00) 50.00 (75.00) 60.00 (70.00) 20.00 (33.00) 40.00 (20.00) 40.00 (35.00) 60.00 (10.00) 15.00 (18.00) 20.00 40.00 5.00 30.00 20.00 36.00 18.00 15.00 15.00 55.00 60.00 30.00 50.00 (3.98) (9.73) 17.78 11.08 5.55% 4.01% 10.74% 9.41%

Figures in the above table are in £’000. Investopedia (2016) defines Net Present Value as “the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of a projected investment or project”. In the given case it is the present value of the expected cash outflows, inflows and expected cash savings (which is considered equivalent to cash inflows). Therefore the expected NPV of the four vendors are £3.98 (outflow), £9.73 (outflow), £17.78 (inflow) and £11.08 (inflow) respectively. Wade’s equipment offers the highest NPV therefore it should be the first choice. However, since the NPV of equipment provided by both Wade and Jones are positive both the proposals are acceptable. “Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero” Investinganswers.com (2016). The IRR of the new machinery provided by the four suppliers are 5.55%, 4.01%, 10.74% and 9.41% respectively. Given that the highest IRR is 10.74%, the equipment provided by Wade is the best choice, but since IRR of equipment provided by both Wade and Jones exceed the lending rate of 7% both the proposals are acceptable. Conclusion Given the economic feasibility analysis of the above consideration. The offers by the suppliers Murray and Perry fall short due to longer payback periods and poorer internal rates of return so are therefore not worth consideration. However in comparing Wade and Jones, Wade offers better NPV and IRR, whereas Jones has a lesser payback period. The difference between the payback periods of the two is not significant. But the difference between the NPV and IRR is definitely considerable. Therefore in conclusion Wade’s equipment is the best choice. However, if the firm is expected to have a shortage of capital

and it requires an investment to payback as soon as possible, then is potentially better to go for the offer made by Jones. N.B.: Two Marks for each technique for the four companies plus four marks for the content and format of the report. 20 Marks...