Question
Hort is an actuarial consultancy. Hort has owned a two floor office block for the past20 years. Improvements in technology mean that Hort has reached
Hort is an actuarial consultancy. Hort has owned a two floor office block for the past20 years.
Improvements in technology mean that Hort has reached the point where the whole ofthe upper floor is left unoccupied.
Hort's directors are considering using the free space in the building to launch a newconsultancy venture. This would involve taking on new consultants with relevantexpertise, as well as equipping the floor with suitable IT equipment.
The initial investment in the IT equipment will be 1.5 million.
Over the next five years, Hort predicts that the fees earned from the new consultancyventure, minus the cash outflows associated with wages and other running costs, willhave a net present value of 4.0 million.
Hort's directors believe that they should allow something for the building in decidingwhether to proceed with this venture. Four possible arguments have been put forwardby four members of the board:
1. The building cost 2.0 million when it was acquired and it has been depreciatedby 800,000 since. That leaves a net book value of 1.2 million, of which 0.6million could be attributed to the upper floor.
2. The cost of the building is a sunk cost and it should not be incorporated into theproject appraisal.
3. The upper floor could be sold to a third party for 2.7 million.
4. The upper floor could be rented out over the next five years, with rental incomeyielding a net present value of 0.9 million.
The debate over the building has been heated because it could affect the decision togo ahead with the project.
(i) Discuss the logic of each of the four arguments concerning the building. [8]
(ii) Explain how Hort's Board should decide on the most appropriate treatment ofthe building. [2]
Critics of the net present value (NPV) technique state that it has a fundamental flaw inthat it is possible to justify either the acceptance or rejection of almost any project by
manipulating estimates and assumptions in the evaluation of NPV.
(iii) Evaluate the assertion that this project illustrates this fundamental flaw in thenet present value criterion. [10]
[Total 20]
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