Advanced: Relevant cash flows and taxation plus unequal lives Pavgrange pic 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

The initial outlay for Project 1 is £2 million and for Project 2 £3~
million.
Tax allowable depreciation is at the rate of 25% 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% 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 year. The company 's weighted average cost of capital is estimated to be 8%
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. (12 marks)

(b) What further information might be helpful to the company accountant in the evaluation of these investments?
{3 marks)

(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 £n ,ooo and (£188,000) respectively, evaluate whether your advice to Pavgrange would change . (5 marks)

(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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Years 1 2 3 (000) (000) (000) Sales 6500 6950 7460 Operating costs 4300 4650 5070 Depreciation 960 720 540 Interest 780 800 800 Profit before tax 460 780 1050 Taxation 161 273 367 Profit after tax 299 507 683 Dividends 200 200 230 Retained earnings 99 307 453 (b) Investment in Project 1 Years 2 3 (000) (000) (000) Sales 7340 8790 9636 Operating costs 4869 5620 6385 Depreciation 1460 1095 821 Interest 1000 1030 1030 Profit before tax 11 1045 1400 Taxation 4 366 490 Profit after tax 7 679 910 Dividends 200 200 230 Retained earnings (193) 479 680