1. VPN plc is a wholesaler of specialist books which is keen to explore the financial implications of making a significant investment in equipment and the development of a website.

Due to the fast-changing nature of the equipment and the internet software, VPN's management has set a project lifetime of three years - that is, the equipment will be replaced at the end of 2021 and a new website designed. 60,000 would be paid for the new equipment on 31^stDecember 2018. The supplier has agreed to pay 10,000 as a trade-in price in December 2021.

VPN's estimated final sales for the current accounting year (which ends on 31^stDecember 2018) are 1,200,000. The company's costs behave in such a way that its contribution to sales ratio for 2018 is expected to be 40% and its net margin 10%. A considerable proportion of VPN's total fixed costs are marketing expenses. The proposed project will lead to savings in this area. So, in 2019, fixed costs (at 31^stDecember 2019 prices) will total 316,800.

Sales estimates are shown below:

Total Sales if no investment Total Sales with investment

() ()

Year to 31^stDecember 2019 1,240,000 1,288,000

Year to 31^stDecember 2020 1,265,000 1,325,000

Year to 31^stDecember 2021 1,290,000 1,362,000

From 1^stJanuary 2019, inflation will have the following effects on VPN's operations:

(i)Sales prices will increase by 5% per annum; and

(ii)All costs (that is, variable and fixed) will increase by 10% per annum.

The increase in sales will mean that VPN will carry an investment in working capital as follows (all at 31^stDecember 2018 prices):

2018 Initially 20,000

2019 Increase of 10,000

2020 Decrease of 15,000

2021 Decrease of 15,000

The investment will also be affected by inflation from 1^stJanuary 2019, at the same annual rate as the variable and fixed costs - that is, 10%.

The website would be designed and installed during the first four months of 2019. It will cost 150,000 (at 2019 prices), payable at the end of 2019.The suppliers will be paid a retaining/ advisory fee of 10,000 in both 2020 and 2021.These are at 31^stDecember 2019 prices and it is anticipated that, due to inflation, they will increase at the same rate as all other costs.

VPN has a nominal cost of capital of 10% and pays tax at an annual rate of 30% in the year profits are earned. It can claim capital allowances on a 25% reducing balance basis.

Required:

(a)Advise the management of VPN whether it should proceed with the proposed investment. Your recommendation should be supported by relevant workings and a calculation of the net present value. You should also state any assumptions that you make.

(26)

(b) Discuss the reasons why the net present value investment appraisal method is preferred to other investment appraisal techniques such as payback, accounting rate of return and internal rate of return.

(14)

(40)