Pavgrange plc is considering expanding its operations. The company accountant has produced pro forma profit and loss accounts for the next three years assuming that:
(a) The company undertakes no new investment.
(b) The company invests in Project 1.
(c) The company invests in Project 2.
Both projects have expected lives of three years, and the projects are mutually exclusive. The pro forma accounts are shown below:
(a) No new investment

b) Investment in Project 1

(c) Investment in Project 2

The initial outlay for Project 1 is £2 million and for Project 2 £3½ million.
Tax allowable depreciation is at the rate of 25 per cent on a reducing balance basis. The company does not expect to acquire or dispose of any fixed assets during the next three years other
than in connection with Projects 1 or 2. Any investment in Project 1 or 2 would commence at the start of the company's next financial year.
The expected salvage value associated with the investments at the end of three years is £750 000 for Project 1, and £1 500 000 for Project 2.
Corporate taxes are levied at the rate of 35 per cent and are payable one year in arrears.
Pavgrange would finance either investment with a three year term loan at a gross interest payment of 11 per cent per year. The company's weighted average cost of capital is estimated to be 8 per cent per annum.
Required:
(a) Advise the company which project (if either) it should undertake. Give the reasons for your choice and support it with calculations.
(b) What further information might be helpful to the company accountant in the evaluation of these investments?
(c) If Project 1 had been for four years duration rather than three years, and the new net cash flows of the project (after tax and allowing for the scrap value) for years four and five were £77 000 and (£188 000) respectively, evaluate whether your advice to Pavgrange would change.
(d) Explain why the payback period and the internal rate of return might not lead to the correct decision when appraising mutually exclusive capital investments.

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2 (£000) (£000) (E000) 1 Years Sales Operating costs Depreciation Interest Profit before tax Taxation Profit after tax Dividends Retained eamings 6500 6950 7460 4650 720 800 780 161 273 367 507 200 0230 4300 960 780 460 5070 540 800 1050 299 683 9930 453 Years (E000) (E000) (E000) Sales Operating costs Depreciation Interest Profit before tax Taxation Profit after tax Dividends Retained earnings 7340 8790 9636 5620 1095 1000 10301030 1045 366 679 200 193 479 680 6385 821 1400 490 910 230 200 (£000) (E000) (£000) 11314 7230 1032 1205 1847 646 1201 6470 1376 Operating costs Depreciation Interest Profit before tax Taxation Profit after tax Dividends Retained earnings 5680 1835 (250) 775 184 591 200 (450 391971 (250) 200