QUESTION TWO: INVESTMENT APPRAISAL (25 MARKS)

Bloom (Pty) Ltd operates tourist attractions in major capital cities. The company is considering opening a new attraction in Southern Africa. The initial capital investment will require a purchase of equipment costing R120 million. The equipment has an estimated useful life of 5 years and will depreciate on a straight-line basis. The scrap value at the end of 5 years is expected to be R50 million.

Revenue and variable costs

It is expected that there will be 880 000 visitors per year and that this number will remain constant per year for the life of the project. The entrance fee for the attraction will be R40 per visitor. Each visitor is expected to spend an average of R15 on souvenirs and R5 on refreshments. The variable costs are estimated to be R25 per visitor. This includes the variable cost of operating the attraction and the cost of souvenirs and refreshments.

Fixed operation costs (all cash)

• The company will lease the land on which the attraction is to be situated at a cost of R500 000 per annum. The lease cost will remain the same throughout the life of the project.
• Maintenance costs are estimated to be R200 000.

Other information

The directors of Bloom (Pty) Ltd currently require all investments to generate a positive net present value at a cost of capital of 12%, and an accounting rate of return of at least 35%. You may assume that all cash flows arise at the end of the year, except for those relating to the initial capital investment of R120 million.

REQUIRED:

Determine whether Bloom (Pty) Ltd should invest in the expansion of its tourist attraction business based on its existing investment criteria.