Question 1 (Examination style question)

The directors of Go Ahead Limited have identified two possible capital investment
projects. Each of these would involve an initial cost of £150,000 and would have an
expected life of 5 years. The cost of capital for the company is 12%. The expected
cash inflows for the two projects are as follows:

Project 1 Project 2
£ £
Year 1 78,000 54,000
Year 2 72,000 60,000
Year 3 48,000 72,000
Year 4 36,000 66,000
Year 5 24,000 48,000

You are required to:

a) Calculate for each project:

i) The Payback Period
ii) The Net Present Value

b) State which one of the two projects should be accepted and explain the reasons
for this choice.

c) Explain why it is important to consider risk and uncertainty when evaluating

capital investment projects. (Covered in next topic)

Continued >
Question 2 (Based on a McLaney & Atrill exercise)
The directors of Diggit Ltd are currently considering two mutually exclusive
investment projects. Both projects are concerned with the purchase of new plant.
The following data are available for each project:

Project
1 2
£000 £000
Cost (immediate outlay) (100) (60)
Expected annual operating profit (loss):
Year 1 29 18
Year 2 (1) (2)
Year 3 2 4
Estimated residual value of plant 7 6

The business has an estimated cost of capital of 10%, and uses the straight-line
method of depreciation for all non-current assets when calculating operating
profit. Neither project would increase the working capital of the business. The
business has sufficient funds to meet all capital expenditure requirements.

Required:

Calculate the:
i) net present value (NPV);
ii) approximate internal rate of return (IRR); and
iii) Payback Period, for each project.

State which, if any, of the two projects should be accepted and explain the
reasons for this choice.

Continued >
Question 3 (Examination style question)

Solent Boatyard plc occupies a large site on a tidal section of the Hamble. The
owners intend to operate the boatyard for the next four years after which time the
site will be sold to another company. Two proposals are currently being considered
by the present owners in an attempt to improve the position of the company
before the sale takes place in four years’ time.

Proposal 1: Spend £510,000 on refurbishing the pontoons and buildings around the
boatyard. It is anticipated that this would result in additional revenue of
approximately £170,000 for each of the next four years. The refurbishment costs
would be paid in equal instalments, half immediately and half at the end of next
year.

Proposal 2: Employ a management consultancy firm to review the company’s

strategy, prepare a marketing package and oversee the operation for the next four
years. The terms being discussed with a consultancy at the moment are for an
initial payment of £510,000 to the consultants with annual fees of £42,500 for each
of the next four years. Recent similar undertakings made by the consultants have
generated a significant improvement in business activity such that additional cash
flows are expected to be £170,000 in each of the next two years £255,000 in year
three and £382,500 in year four.

Solent Boatyard plc is able to obtain finance for either of these proposals with
little problem, at an interest rate of 10% per annum.

You are required to:

a) Calculate both the payback period and the net present value for each proposal.
b) Recommend one of the proposals to the owners of the boatyard, giving reasons
for the decision.
c) What other factors should the owners of the boatyard consider before finally
making a decision on the future strategy?

Question 4 (Lumby – altered)

Stanchion plc is considering investing in a project that will require a capital

expenditure outlay of £300,000. It will have a four-year life and, at the end of that
time, the equipment used will be sold off for £100,000. In addition, £38,000 of
working capital will be required from the start of the project, and this figure will
have to be increased to £50,000 at the end of the second year. All working capital
will be recovered at the end of the project’s life.

The project is expected to generate revenues of £100,000 in the first year and
£200,000 per year thereafter. Annual cash operating costs are expected to be
£60,000 in the first year and £80,000 per year thereafter. The company believes
that a discount rate of 10% would be appropriate. (Lumby – altered)

Required:
Calculate the net present value for the project.