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Financial Analysis Results for Investment Opportunities

Question 1

Payback

A = 5 + (500/900)Â  Â  Â  =Â  Â  5.5 years
B = 5 + (500/1,200)Â  Â  =Â  Â  5.4 years
C = 2 + (1,000/2,000) =Â  Â  2.5 years

Net Present Value

NPVA = (900 x 6.145) - 5,000= 5,530.5 - 5,000 = Â£530.5

NPVB is calculated as follows:

 Year Cash flow (Â£) 10% discount factor PV (Â£) 0 (5,000) 1.000 (5,000) 1 700 0.909 Â Â 636 2 800 0.826 Â Â 661 3 900 0.751 Â Â 676 4 1,000 0.683 Â Â 683 5 1,100 0.621 Â Â 683 6 1,200 0.564 Â Â 677 7 1,300 0.513 Â Â 667 8 1,400 0.467 Â Â 654 9 1,500 0.424 Â Â 636 10 1,600 0.386 Â Â 618 Â Â Â 1,591

NPVC = (5,000) + (2,000 x 2.487) + (1,000 x 0.683) = Â£657

If NPVA = 0, present value factor of IRR over 10 years = 5,000/ 900 = 5.556

From tables, IRR ~ 12%

 Year Cash flow (Â£) 10% discount factor PV (Â£) 20% discount factor PV (Â£) 0 (5,000) 1.000 (5,000) 1.000 (5,000) 1 700 0.909 636 0.833 583 2 800 0.826 661 0.694 555 3 900 0.751 676 0.579 521 4 1,000 0.683 683 0.482 482 5 1,100 0.621 683 0.402 442 6 1,200 0.564 677 0.335 402 7 1,300 0.513 667 0.279 363 8 1,400 0.467 654 0.233 326 9 1,500 0.424 636 0.194 291 10 1,600 0.386 618 0.162 259 Â Â Â 1,591 Â (776)

interpolating: Â IRRB = 10 + Â  1591 Â x Â 10/(1,591 + 776) = 10 + 6.72 = 16.72 %

 Year Cash flow (Â£) 15% discount factor PV (Â£) 18% discount factor PV (Â£) 0 (5,000) 1.000 (5,000) 1.000 (5,000) 1 2,000 0.870 1,740 0.847 1,694 2 2,000 0.756 1,512 0.718 1,436 3 2,000 0.658 1,316 0.609 1,218 4 1,000 0.572 Â Â Â 572 0.516 Â Â Â 516 Â Â Â Â Â Â 140 Â Â (136)

interpolating: Â IRRC = 15 + 140 x 3/(140 + 136) = 15 + 1.52 = 16.52%Â  Â  Â  Â  Â  Â  Â  Â Â

ARRA:
Average capital employed = 5,000/ 2 = Â£2,500
Average accounting profit = (9,000 - 5,000)/ 10 = Â£400
ARRA =100 x (400 x 100)/ 2,500 = 16%

ARRB:
Average accounting profit = (11,500 - 5,000)/ 10 = Â£650
ARRB = 100 x (650 x 100)/ 2,500 = 26%

ARRC:
Average accounting profit = (7,000 - 5,000)/ 4 = Â£500
ARRC = 100 x (500 x 100)/ 2,500 = 20%

Summary of Results:

 Project A B C Payback (years) 5.5 5.4 2.5 ARR (%) 16 26 20 IRR (%) 12.4 16.7 15.5 NPV (%) 530.5 1,591 657

(a) Annual costs = Â£400,000 per year
Annual net cash income = 600,000 - 400,000 = Â£200,000 per year
Payback period = 900,000/ 200,000 = 4.5 years

Average annual accounting profit = ((200,000 x 8) - 800,000)/ 8 = Â£100,000
Average investment = (800,000/2 + 100,000) = Â£500,000
Accounting rate of return = (100,000/ 500,000) x 100 = 20%

NPV at 11% = (200,000 x 5.146) + (100,000 x 0.434) - 900,000 = Â£172,600
NPV at 20% = (200,000 x 3.837) + (100,000 x 0.233) - 900,000 = (Â£109,300)

IRR = 11 + ((9 x 172,600)/ (109,300 + 172,600)) = 16.5%

No comment can be made on investment acceptability from an ARR point of view, since a hurdle return on capital employed or target ARR is needed with which to compare the calculated ARR. The same comment can be made with respect to payback period, since a target payback period is needed with which to make an evaluative comparison. As the NPV is positive, the project is acceptable, since the NPV decision rule is to accept all projects with a positive NPV. This is also the conclusion from the IRR method, since the calculated IRR is greater than the cost of capital of LJH plc

(b) Â  Â If a company is restricted in the amount of investment capital available, it is said to be in a capital rationing situation and will not be able to undertake all projects with a positive net present value. Shareholder wealth maximisation will therefore not be achieved. Capital rationing may be either soft or hard. Soft rationing is due to internal factors and hard capital rationing is due to external factors. Soft capital rationing may arise for several reasons, including:

(1) Managers may choose to adopt a policy of stable growth.

(2) Managers may be reluctant to issue new equity

(3) Managers may wish to avoid commitment to further fixed interest debt.

(4) Managers may restrict investment funds to encourage competition.

When capital is rationed and projects are divisible, they can be ranked using the profitability index in order to identify the order in which to invest in them. If projects are non-divisible, combinations of projects must be evaluated in order to find the one which offers the highest NPV. When capital is rationed, ranking by absolute NPV will not indicate which projects are preferable from a wealth-increasing perspective.

(a) NPV A

 Year Cash flow 12% DF PV (Â£m) 0 (150) 1.000 (150) 1 40 0.893 35.7 2 50 0.797 39.9 3 60 0.712 42.7 4 60 0.636 38.1 5 85 0.567 48.2 Â Â NPV 54.6

 NPV B Â Â Â Year Cash flow 12% DF PV (Â£m) 0 (152) 1 (152) 1 80 0.893 71.4 2 60 0.797 47.8 3 50 0.712 35.6 4 40 0.636 25.4 5 30 0.567 17.0 Â Â NPV 45.3

(b) IRR A
NPV @ 20% = Â£15.9m

Therefore IRR is given by:
12% + ((20% - 12%) x 54.6)/ (54.6 - 15.9) = 23.3%

IRR B: NPV @ 20% = Â£16.6m

Therefore IRR is given by:
12% + ((20% - 12%) x 45.6)/ (45.6 - 16.6) = 24.6%

(c) NPV suggests the adoption of project A while IRR suggests project B. The contrary conclusions arise due to the cash flows of Project A coming later in its life. In this situation NPV should be followed and project A accepted.

NPV(A) = -1,000 + (3,000 x 0.467)Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  = Â£401
NPV(B) = -800 + (200 x 0.909) + (300 x 0.826) + . . . Â  Â = Â£451
NPV(C) = -750 + (300 x 3.791)Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  = Â£387
NPV(D) = -500 + (150 x 4.868)Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  = Â£230
NPV(E) = -800 + (350 x (4.868 - 0.909))Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  = Â£586

 Project A B C D E Benefit/Cost Ratio 1.401 1.564 1.516 1.462 1.732

(a) Non-capital rationing situation: accept all projects

(b) Investment schedule: Â  Â  Â

Â£800 in project E
Â£800 in project B
Â£750 in project C
Â£150 in project D

Total NPV = Â£1,493

(c) Investment schedule: Â  Â  Â  Â

Â£800 in project E
Â£800 in project B
Â£750 in project C
Total NPV = Â£1,424
Surplus funds = Â£150Â  Â  Â  Â  Â  Â  Â  Â Â