Caravantura Escapes Lda (CEL) is a large Portuguese company specialising in static caravan park holidays. It owns and operates a number of these parks throughout Portugal. There are both lodges and static caravans at each of CELs parks. Both the lodges and the static caravans are at the luxury end of the market and CEL enjoys a firstclass reputation in providing this type of holiday. Two months ago, the Board of Directors was looking at various expansion projects and decided to purchase for 2.25 million a large strip of coastal land in the southern Algarve, close to the busy city of Albufeira. This was done with a view to developing this land extensively and turning it into CELs flagship caravan park and resort. The CEO has named the venture Project Flagship. Since this land purchase, CEL has spent an additional 1.75 million preparing the ground for construction work. Out of the blue, another holiday company has made an offer of 6.50 million for the strip of land, forcing the Board of Directors to reappraise Project Flagship in order to decide whether to proceed with it or accept the surprise offer. If the Board of Directors decides to accept the offer, the sale will take place immediately, incurring legal fees of 100,000. If the Board of Directors rejects the offer, development will continue and the lodges and static caravans will be available for rent in one years time. The CFO has provided estimates of costs and revenues for Project Flagship covering the next five years as follows: All the set-up costs will occur within the next year, before the resort is open. The annual revenues and overheads relate to the four years following this. Projected construction costs for 150 luxury lodges on the land are 17.20 million. Of this total, 2.20 million has already been spent in the form of irrecoverable up-front payments to several building companies. Every lodge will have its own private pool and jacuzzi at a cost of 10,000 for each lodge. Annual revenues from the lodges are anticipated to be 10.00 million, incurring 2.50 million overheads per annum to operate. Projected purchase costs for 200 static caravans are 12.00 million. An immediate upfront payment of 20% would be due to the main supplier of these caravans. Annual revenue from each static caravan is estimated at 52,000 with maintenance costs for each caravan of 5,000 per annum. There will also be a jet ski school built on the beach adjoining the land. The cost of this including all the necessary equipment is estimated at 1.20 million. There will be four differently themed restaurants built on the resort costing a total of 8.00 million and CEL is already committed to 1.00 million of these costs in order to attract top-rated chefs. Although this 1.00 million has not yet been paid, CEL is contractually bound to pay this, irrespective of whether the project proceeds. A small parade of exclusive boutiques and souvenir shops will be constructed at a total cost of 3.75 million. The four restaurants and the parade of boutiques and souvenir shops are expected to generate net income of 3.00 million per annum, in total. Depreciation totalling 3.45 million per annum will be charged in CELs accounts for the site. Interest on money borrowed to finance the project will be 3.25 million per annum. Corporate taxation at 21% of profits is payable a year in arrears. There are no tax allowances available on any of the construction or capital purchase costs made by CEL. CELs cost of capital is 10%.

Required:

1. Explain the main principles used to differentiate between relevant and irrelevant costs for investment appraisal, using Project Flagship to illustrate your answer.

2. Determine the net present value of Project Flagship (NPV) and evaluate whether CEL should proceed with the project. Show all workings.

3. With regard to the key variables that you used in your evaluation of Project Flagship in requirement 2, critically assess the limitations of your evaluation and recommend some actions that the Board of Directors might take to mitigate any limitations.