Investment Appraisal: Northern Fuels Ltd

Answered

Background

After graduation from your programme, you team up with your college friend Diana Hinds to set up PH Consultancy and use your 25 years of combined business experience and freshly acquired academic knowledge to realise your career aspirations. One of your first clients is Northern Fuels Ltd, which is an oil distributor in Scotland and the North of England. William Redcartson, who is the managing director of Northern Fuels, asked your consultancy firm to advice his Board of Directors on the potential of expanding the operations of the company.

The investment opportunity that Northern Fuels Ltd is considering is to buy a small tanker ship to deliver refined oil-to-oil suppliers in the Faroe Islands. Northern Fuels has commissioned and paid £50,000 for a market research and preliminary feasibility study. It has also commissioned the ship dealer NeptunPort Ltd, and has already paid £100,000 to find an appropriate tanker ship. NeprunePort has found and inspected a small 3,000 tones capacity tanker ship, which is available, for the price of £14,000,000, if Northern Fuels decides to progress with this investment.

The information from the market report and other sources that William Redcartson has given you about the prospective investment, is as follows:

The investment will last four years and if the investment is profitable, the ship should be purchased now, at the start of the new accounting year, and the operations should start immediately.

The expected deliveries for the four years of the investment are:

For each tonne of oil delivered, Northern Fuels will receive £50. The investment will also be entitled to government subsidy of £5,000 per delivery and this subsidy will have no tax impact for Northern Fuels.
There is a cost of £6 per tonne, to load the oil from the refinery to the tanker and for each delivery, an expense of £50,000 for the cost of the voyage fuel of the tanker ship. For the administration of the new investment, Northern Fuels will have to lease new premises, purchase equipment and hire admin staff, with total annual cost of £240,000. There will also be an additional annual labour cost of £600,000.
The cost for service and maintenance will be £320,000 per annum.
The purchase of the ship will be subject to a reducing balance depreciation at 25% rate every year, except in the last year, of the disposal of the ship, when the balancing charge to the disposal price will be made.
It is assumed that all the cash flows will occur at the end of the year.
Northern Fuels would like to use a 12% discount rate for the investment appraisal.
All expenses and revenues will be subject to 3% annual inflation rate.

You have completed the analysis and were in the office working with Diana on the finishing touches of the report and your scheduled presentation to the next day’s Board Meeting at the Headquarters of Northern Fuels, when the phone rang. It was William Redcartson, who called to say that the Chair of the Audit Committee has asked to include in your report the sensitivity analysis of the investment’s NPV in respect to the price that Northern Fuels can charge per tonne of oil delivered and the resale price of the ship at the end of the four-year investment period. Before you start panicking, Diana explained that this is a very simple task and you only need to find what is the proportion of the NPV of the investment in respect to what the NPV would have been if you ignore all the expenses and how much the resale price of the ship can change to wipe out any positive gains from the investment.

Required:

(a) Estimate the Net Present Value of the investment, showing clearly all your calculations. (50 marks)

(b) Estimate the Internal Rate of Return of the investment, showing clearly all your calculations. (10 marks)

(c) Estimate the sensitivity of the NPV to the price of the delivery per tonne that Northern Fuels can charge. (20 marks)

(d) Estimate the sensitivity of the NPV to the resale price of the ship. (10 marks)

(e) Write a short section in your report to explain to the members of the Board of Northern Fuels the reasons that you adopt the NPV appraisal method against the other possible alternative investment appraisal methods. Include in this section a discussion of the critical factors that might affect the outcome of this investment. (10 marks)

Your challenge is to make your points clear and develop short, convincing and factual arguments, making your report clear and readable using proper structure and reasoned discussion. Presenting your calculations clearly and precisely will enhance the overall quality of your report. Your report should not be longer than 2,000 words. The cover page, formulas, tables, reference list and any appendices do not count towards the overall word count. You should make your report clear and comprehensive as well as complete to read.

The report should include the following sections:

Title Page
Introduction
Analysis and presentation of your findings. Your presentation should be clear and include any formulas and summary calculations in the main body of your report.
Critical discussion and recommendations to the management of the company and other parties
Overall reflection and conclusion
References
Appendices (include data, information and any detailed calculations)