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Two mutually exclusive investments with an expected life of five years are being
considered by the Board of ABC PLC.
ABC PLC does not have the physical capacity to undertake both investments.
The second investment is relatively capital intensive while the first is relatively labour
intensive.
Forecast returns on the two investments are as follows:Investment 1 (requires 10 new workers)
£000’s
Year 0 1 2 3 4 5
Initial cost 250
Projected revenue 360 480 530 560 500
Production charges 210 240 250 252 200Investment 2 (requires 2 new workers)
£000’s
Year 0 1 2 3 4 5
Initial cost 600
Projected revenue 420 510 580 600 525
Production charges 190 230 260 270 230
Finance charges 60 60 60 60 60
Additional information:
1. Tax is at 25% per annum and is paid a year in arrears.
2. Investment 1 would be financed from internal funds, which the managing director
states have no cost to the business. Investment 2 would be financed by internal
funds plus a £475,000 12.00% fixed rate term loan.
3. There is no adjustment for price changes. These have been ignored in the
projections as both revenues and production costs are expected to increase by 6%
each year after the first year.
4. The entity’s overall cost of capital is 5% and the inflation rate is predicted to be 5%
for the foreseeable future.
5. All cash flows may be assumed to occur at the end of the year unless otherwise
stated.
6. Both investments are expected to have negligible scrap value at the end of 5
years.(a) Which one investment, if any, should be selected?
For both projects you need to calculate the net present value and choose whichever gives the highest NPV (or if both are negative NPV’s then choose neither).
The cash flows for investment 1 are the projected revenue less the production charges. In the first year it is the difference in the figures given, in later years they need inflating at 6% p.a.. (If you are unsure about how to do this, then watch my free lecture on investment appraisal).
The same applies for investment 2 except that the finance charges each year are not relevant (they are taken account of by the discounting).
In both cases, the flows will be discounted at the weighted average (overall) cost of capital.
Here however there is something very wrong with the question (unless you have mistyped it). It is not possible for the WACC to be 5%. Also, it does not state whether 5% is the nominal or the real cost of capital (if it is the real cost of capital, then it needs adjusting by the general inflation rate).
Hope that helps.
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