IM14.6 Advanced: Relevant cash flows and taxation plus unequal lives Pavgrange plc is considering expanding its operations. The company accountant has produced pro forma profit and loss accounts for the next three years assuming that:

1. The company undertakes no new investment.
2. The company invests in Project 1.
3. The company invests in Project 2.

Both projects have expected lives of three years, and the projects are mutually exclusive.

The pro forma accounts are shown below:

1. No new investment

Years	1	2	3
	(000)	(00)	(000)
Sales	6500	6950	7460
Operating costs	4300	4650	5070
Depreciation	960	720	540
Interest	780	800	800
Profit before tax	460	780	1050
Taxation	161	273	367
Profit after tax	299	507	683
Dividends	200	200	230
Retained earnings	99	307	453

2. Investment in Project 1

Years	1	2	3
	(000)	(00)	(000)
Sales	7340	8790	9636
Operating costs	4869	5620	6385
Depreciation	1460	1095	821
Interest	1000	1030	1030
Profit before tax	11	1045	1400
Taxation	4	366	490
Profit after tax	7	679	910
Dividends	200	200	200
Retained earnings	(193)	479	680

3. Investment in Project 2

Years	1	2	3
	(000)	(00)	(000)
Sales	8430	9826	11314
Operating costs	5680	6470	7230
Depreciation	1835	1376	1032
Interest	1165	1205	1205
Profit before tax	(250)	775	1847
Taxation	0	184	646
Profit after tax	(250)	591	1201
Dividends	200	200	230
Retained earnings	450	391	971

The initial outlay for Project 1 is 2 million and for Project 2 is 3.5 million. Tax allowable depreciation is at the rate of 25 percent on a reducing balance basis. The company does not expect to acquire or dispose of any fixed assets during the next three years other than in connection with Project 1 or 2. Any investment in Project 1 or 2 would commence at the start of the companys next financial year.

The expected salvage value associated with the investments at the end of three years is 750,000 for Project 1 and 1,500,000 for Project 2.

Corporate taxes are levied at the rate of 35 percent and are payable one year in arrears.

Pavgrange would finance either investment with a three year term loan at a gross interest payment of 11 percent per year. The companys weighted average cost of capital is estimated to be 8 percent per annum.

Required

1. Advise the company which project (if either) it should undertake. Given the reasons for your choice and support it with calculations.
2. What further information might be helpful to the company accountant in the evaluation of these investments?
3. If Project 1 had been for four years duration rather than three years, and the new net cash flows of the project (after tax and allowing for scrap value) for years four and five were 77,000 and (188,000) respectively, evaluate whether your advice to Pavgrange would change.
4. Explain why the payback period and the internal rate of return might not lead to the correct decision when appraising mutually exclusive capital investments.