Flyers plc operates public transport services in major cities in the United Kingdom (UK). The company uses the accounting rate of return (ARR) and payback methods to support investment decision-making. You are a Senior Finance Manager at Flyers plc.

The company intends to bid for new five-year contracts to operate bus services in either Edinburgh, UK, or Newcastle upon Tyne, UK. Both contracts require the successful bidder to pay a franchise fee to secure the contract and to invest in a new fleet of buses. Sufficient funding is available to finance only one of these options.

Assume that all cash flows occur at the end of the respective year.

The company’s approach to investment appraisal was discussed at a recent meeting of Flyers plc’s senior executive team. Chang Ying Simmonds, Director of Marketing at Flyers plc, is keen to understand the nature of investment decisions. Chang Ying has commented:

These decisions appear to have particular characteristics. We need to understand why investment decisions are of importance to the business as this will help us to appreciate if our approach to investment appraisal is appropriate.

Travis van Riemsdyk, Chief Operating Officer at Flyers plc, has highlighted that the internal rate of return (IRR) method can be of use in investment appraisal. Travis has commented:

Like other investment appraisal methods, the IRR has both advantages and disadvantages. I would like to know more about the strengths and weaknesses of the IRR.

Required:
(a) Calculate the payback period for both the Edinburgh and Newcastle upon Tyne contracts.
(b) Calculate the accounting rate of return (ARR) for both contracts. Assume that the only difference between cash flow and profit is the depreciation charge.
(c) Critically evaluate the payback technique.
(d) Advise Flyers plc’s senior executive team on the comments made by Chang Ying Simmonds and Travis van Riemsdyk. Your advice should include an explanation of the characteristics of investment appraisal decisions and the advantages and disadvantages of the IRR.
 

Franchise fee (year 0) New buses (year 0) Scrap value (year 5) Forecast net cash inflows Year 1 Year 2 Year 3 Year 4 Year 5 Edinburgh 000 8,700 4,120 110 3,780 4,150 4,550 5,120 4,900 Newcastle 000 7,950 3,890 95 3,500 3,850 4,200 5,150 4,950