Critical Evaluation of the Use of Net Present Value Method in Capital Investment Appraisal

If there are any exceptional circumstances that may have affected your ability to undertake or submit this assignment, make sure you contact the Advice Centre on your campus prior to your submission deadline.

The University operates a fit to sit policy whereby you, in submitting or presenting yourself for an assessment, are declaring that you are fit to sit the assessment.  You cannot subsequently claim that your performance in this assessment was affected by extenuating factors.

By submitting this assessment, you declare that it is your own work and that the sources of information and material you have used (including the internet) have been fully identified and properly acknowledged as required[ University Academic Integrity Regulations].  Additionally, the work presented has not been submitted for any other assessment.  You also understand that the Faculty reserves the right to investigate allegations of plagiarism or unfair practice which, if proven, could result in a fail in this assessment and may affect your progress.

Using quality academic material write a critical evaluation of the use of the Net Present value method as the key analytical tool in capital investment appraisal

You are working for Ridley Co and are reviewing a four-year project, which the company is considering for investment. The project is in a business activity which is very different from Ridley Co’s current line of business.

The following net present value estimate has been made for the project:

Net present value is negative £1·65 million, and therefore the recommendation is that the project should not be accepted.

In calculating the net present value of the project, the following notes were made:

(i)Since the real cost of capital is used to discount cash flows, neither the sales revenue nor the direct project costs have been inflated. It is estimated that the inflation rate applicable to sales revenue is 8% per year and to the direct project costs is 4% per year.

(ii)The project will require an initial investment of £38 million. Of this, £16 million relates to plant and machinery, which is expected to be sold for £4 million when the project ceases, after taking any taxation and inflation impact into account.

(iii)Tax allowable depreciation is available on the plant and machinery at 50% in the first year, followed by 25% per year thereafter on a reducing balance basis. A balancing adjustment is available in the year the plant and machinery is sold. Ridley Co pays 20% tax on its annual taxable profits. No tax allowable depreciation is available on the remaining investment assets and they will have a nil value at the end of the project.

(iv)Ridley Co uses either a nominal cost of capital of 11% or a real cost of capital of 7% to discount all projects, given that the rate of inflation has been stable at 4% for a number of years.

(v)Interest is based on Ridley Co’s normal borrowing rate of 150 basis points over the 10-year government yield rate.

(vi)At the beginning of each year, Ridley Co will need to provide working capital of 20% of the anticipated sales revenue for the year. Any remaining working capital will be released at the end of the project.

(vii)Working capital and depreciation have not been considered in the net present value calculation above, since depreciation is not a cash flow and all the working capital is returned at the end of the project. It is anticipated that the project will be financed entirely by debt, 60% of which will be obtained from a subsidised loan scheme run by the government, which lends money at a rate of 100 basis points below the 10-year government debt yield rate of 2·5%. Issue costs related to raising the finance are 2% of the gross finance required. The remaining 40% will be funded from Ridley Co’s normal borrowing sources. It can be assumed that the debt capacity available to Ridley Co is equal to the actual amount of debt finance raised for the project.

Ridley Co has identified a company, Lifeline Co, which operates in the same line of business as that of the project it is considering. Lifeline Co is financed by 40 million shares trading at £3·20 each and £34 million debt trading at £94 per £100. Lifeline Co’s equity beta is estimated at 1·5. The current yield on government treasury bills is 2% and it is estimated that the market risk premium is 8%. Lifeline Co pays tax at an annual rate of

Both Ridley Co and Lifeline Co pay tax in the same year as when profits are earned.

Discuss with reference to relevant academic literature the principal uncertainties associated with this project.                               

Discuss the possible actions Ridley Co could take to reduce the risk that the project fails to increase shareholder value.

A critique of the main issues of Ridley using 100% debt funding to finance the project.