(a) Sparkly Ltd, a house-building group, is considering bidding at an auction, to be held next week, for an old agricultural building in the Green Belt. The auctioneer, who will be conducting the auction, believes that that the building will be sold at about£400,000. The business wants to convert the building into a block of ten one-bedroom apartments to be sold at a forecast price of £200,000 each.
The works will be in two stages and these will take two years. Stage One, covering the first year of the project, will cost £800,000. The company expects to complete and sell six apartments at the end of the first year. During Stage Two planned for the second year, the remaining four apartments will be completed at an estimated total cost of £650,000 and sold at the end of the second year. Sparkly’s cost of financing is 5 percent per annum.
The threshold for the acceptability of the project is a non-negative NPV (net present value). The estimates of conversion costs produced by the project’s team inflation. Assume that cash flows arise at the end of the year to which they relate.
The manager does not expect capital to be in short supply during the next two years.
Required:
(i) What is the NPV of the proposed project?
(ii) Now, suppose that none of the other inputs deviate from the estimates provided. What is the maximum tolerable unfavorable change in:
- sale price of the apartment,
- the cost of financing?
(iii) How would you explain the results in part (ii)? Is the level of risk associated with the findings high or low?
You must show computations and workings and state assumptions you have made clearly and neatly.
(b) Briefly discuss the merits and demerits of the internal rate of return rule. rebased on similar cost estimates for residential apartment conversions and have been agreed with a team of local cost consultants. The assumptions about the selling price of apartments and the cost of financing are based on forecasts made by the firm’s finance team. The manager, who is currently reviewing the net present value calculations, wants to explore how sensitive the project will be to possible adverse movements in the apartment sale price and in the cost of financing.
Assume that each apartment must be sold for the same price. Ignore taxation and inflation.