Question
Osiadan Limited is a local real estate company that wishes to expand its operations. Six possible capital investments have been identified, but the company only
Osiadan Limited is a local real estate company that wishes to expand its operations. Six possible capital investments have been identified, but the company only has access to a total of $620,000. The projects are not divisible and may not be postponed until a future period. After the projects end it is unlikely that similar investment opportunities will occur.
Expected net cash inflows (including salvage value)
Project | Year 1 $ | Year 2 $ | Year 3 $ | Year 4 $ | Year 5 $ | Initial Outlay $ |
A | 80,000 | 80,000 | 80,000 | 80,000 | 80,000 | 246,000 |
B | 80,000 | 97,000 | 74,000 |
|
| 180,000 |
C | 68,000 | 68,000 | 83,000 | 83,000 |
| 175,000 |
D | 72,000 | 72,000 | 72,000 | 72,000 |
| 180,000 |
E | 50,000 | 50,000 | 50,000 | 80,000 | 40,000 | 180,000 |
F | 45,000 | 92,000 | 92,000 |
|
| 150,000 |
Project A and E are mutually exclusive. All projects are believed to be of similar risk to the companys existing capital investments.
Any surplus funds may be invested in the money market to earn a return of 9% per year. The money market may be assumed to be an efficient market.
Osiadan Limited has the following information in its statement of financial position;
$000
Ordinary shares of $0.5 2,500
12% unsecured bonds 1000
The ordinary shares are currently quoted at $1.3 each and the bonds are trading at $72 per $100 nominal. The ordinary dividend of $0.15 has just been paid with an expected growth rate of 10%. Corporation tax is currently 30%.
Required
- Calculate the expected net present value for each of the six projects.
- Calculate the expected profitability index associated with each of the six projects.
- Rank the projects according to both of these investment appraisal methods. Explain briefly why these rankings differ.
- Give reasoned advice to Osiadan Limited recommending which project should be selected.
- A director of the company has suggested that using the companys normal cost of capital might not be appropriate in a capital rationing situation. Explain whether you agree with the director.
This subject is Financial Management
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