Investment Appraisal

In a small seaside community called Reform Village, a huge company is proposing to enter one of two projects. Project A is to build a five-storey hotel on the pristine beachfront of Reform Village. Project B is to build twenty self- contained log cabins along the beach with an additional two cabins for a restaurant and health spa.

Each project requires an initial investment of $2 000 000 and has no salvage value. The investing company estimates the cost of capital to be 10%. The company must choose either project A or Project B. The following cash flows are projected for Project A and Project B over five years

Year Project A Project B

2000 600,000 0

2001 600,000 400,000

2002 600,000 400,000

2003 600,000 1,000,000

2004 600,000 1,800,000

Additional Information

The citizens of Reform Village are divided over which project will benefit the villagers most. Some villagers prefer the high-rise hotel because of its potential for more jobs for villagers as cleaners, cooks and waiters. In addition, villagers perceive that during the construction the need for ordinary and skilled labour will help the large proportion of unemployed young men in the village.

Some villagers on the other hand, believe the high-rise hotel will threaten the local ecology by its sheer size and extensive tunnelling necessary to erect such a structure on the beachfront. These villagers will prefer to see smaller, less imposing cabins constructed that will maintain the village theme ant that will not significantly affect the natural environment. Labour for the construction of these cabins will be somewhat less than for the hotel but very skilled carpenters will be needed. There will be a high demand for cooks, cleaners and swimming instructors as the cabin project will target families and aim to meet their personal needs for special foods, baby sitters and cleaners. The villagers are a very powerful group and can have an influence on the profitability of either project.

Required:

1. Explain the concept of time value of money.
2. Compute the payback period on each project.
3. Using the payback period criterion, which project is more desirable?
4. Compute the net present value of each project.
5. Using the NPV criterion, which project is more desirable?

6. List three non-financial factors mentioned in the problem which are important for evaluating whether to invest in Project A or Project B. [3 marks]
7. Based on your calculations of the payback period, net Present Value and the non- financial factors listed in (f) discuss why the investors should choose:

(i) Project A (ii) Project B

TOTAL 30 MARKS