Assume Old mutual decided to diversify four years ago. They decided to provide medical aid services. They opened a new division providing a range of medical aid products to customers. Management at the new division is currently appraising a major capital investment project. The managers are considering opening a new specialist offering in a wing of the current building that is currently unused to service their high income customers. If the decision is made to proceed with the investment, that section of the building will be refurbished, and the staff would be recruited immediately. Servicing of customers could then start straight away. In assessing the viability of capital projects, the division currently uses a target accounting rate of return of 20% (based on the average investment over the period) and a target payback period of three years. It will undertake a project only if BOTH the accounting rate of return and the payback period meet or exceed the targets. The following data are available for this proposed investment.

Cost of refurbishment 30,000,000

Annual increased revenues 20,000,000

Annual increased staff costs (5,300,000)

Annual increased other costs* (4,200,000)

* No depreciation is included in these figures. After six years, it is thought that most of the fittings would have become outdated and would have a residual value of only R6 million. The companys cost of capital is 10% per annum.

iii. Calculate the accounting rate of return and the payback period for the project and recommend on a purely financial basis whether the project should proceed.

iv. You have mentioned to the managers that the net present value method is another valuable method of investment appraisal and that it may give a more accurate representation of whether the project should proceed. The managers have never heard of this method. Recommend whether the project should proceed using this basis of investment appraisal. Show all workings clearly.

v. Distinguish between net profit and net cash flow and explain the rationale for discounting cash flows in the appraisal of capital investment project viability.