Show your working and accurate calculations.

1. Mutually exclusive projects

A company is considering which of two mutually exclusive projectsit should undertake. The finance director thinks that the project withthe higher NPV should be chosen, whereas the managing director thinksthat the one with the higher IRR should be undertaken, especially asboth projects have the same initial outlay and length of life. Thecompany anticipates a cost of capital of 10%, and the net after tax cashflows of the projects are as follows:

Required:

(a)Calculate the NPV and IRR of each project.

(b)Recommend, with reasons, which project you would undertake (if either).

(c)Briefly explain the inconsistency in ranking of the two projects in view of the remarks of the directors.

(d)Discuss the advantages anddisadvantages of the payback and accounting rate of return methods ofinvestment appraisal. Note: you are not required to perform anycalculations for these two methods; if you do, you will not score anymarks for it.

2. ARG Co

ARG Co is a leisure company that is recovering from a loss-makingventure into magazine publication three years ago. The company plans tolaunch two new products, Alpha and Beta, at the start of July 20X7,which it believes will each have a life-cycle of four years. Alpha isthe deluxe version of Beta. The sales mix is assumed to be constant.Expected sales volumes for the two products are as follows:

The selling price and direct material costs for each product in the first year will be as follows:

Incremental fixed production costs are expected to be $1 million inthe first year of operation and are apportioned on the basis of salesvalue. Advertising costs will be $500,000 in the first year of operationand then $200,000 per year for the following two years. There are noincremental non-production fixed costs other than advertising costs.

In order to produce the two products, investment of $1 million inpremises, $1 million in machinery and $1 million in working capital willbe needed, payable at the start of July 20X7.

Selling price per unit, direct material cost per unit andincremental fixed production costs are expected to increase after thefirst year of operation due to inflation:

These inflation rates are applied to the standard selling priceand direct material cost data provided above. Working capital will berecovered at the end of the fourth year of operation, at which timeproduction will cease and ARG Co expects to be able to recover $1.2million from the sale of premises and machinery. All staff involved inthe production and sale of Alpha and Beta will be redeployed elsewherein the company.

ARG Co pays tax in the year in which the taxable profit occurs atan annual rate of 25%. Investment in machinery attracts a first-yearcapital allowance of 100%. ARG Co has sufficient profits to take thefull benefit of this allowance in the first year. For the purpose ofreporting accounting profit, ARG Co depreciates machinery on a straightline basis over four years. ARG Co uses an after-tax money discount rateof 13% for investment appraisal.

Required:

(a)Calculate the net present value of the proposed investment in products Alpha and Beta as at 30 June 20X7.

(18 marks)

(b)Identify and discuss any likely limitations in the evaluation of the proposed investment in Alpha and Beta.

3. H Co

H Co is considering purchasing a new machine to alleviate abottleneck in its production facilities. At present, it uses an oldmachine which can process 8,000 units of Product P per week. H couldreplace it with machine AB, which is product-specific and can produce20,000 units per week. Machine AB costs $500,000. Removing the oldmachine and preparing the area for machine AB will cost $20,000.

The company expects demand for P to be 12,000 units per week foranother three years. After this, in the fourth year, the new machinewould be sold for $50,000. This sale is not expected to take place untillater in the fourth year. The existing machine will have no scrapvalue. Each P sells for $7.00 and has a contribution to sales ratio of0.2. The company works for 48 weeks in the year. H Co normally expects apayback within two years and its after-tax cost of capital is 10% perannum.

The company pays corporation tax at 30% and receives writing-downallowances of 25%, reducing balance on the investment and any costsincurred in removing the old machine and installing the new machine.Corporation tax is payable one year in arrears.

Required:

(a)Calculate the net present value for the machine.

Make the following assumptions:

(i)The company's financial year begins on the same day that the new machine would be purchased.

(ii) The company uses discounted cash flow techniques with annual breaks only.

(b)Recommend, with reasons, whether the machine should be purchased. Include any reservations you may have about your decision.

(c)The investment decision in part(a) is a closely-defined manufacturing one. Explain how a marketing oran IT investment decision might differ in terms of approach andassessment.

4. Quadrant

Quadrant is a highly geared company that wishes to expand itsoperations. Six possible capital investments have been identified, butthe company only has access to a total of $620,000. The projects may notbe postponed until a future period. After the projects end, it isunlikely that similar investment opportunities will occur.

Expected net cash flows (including residual values) are:

Projects A and E are mutually exclusive. All projects are believedto be of similar risk to the company's existing capital investments.

Any surplus funds may be invested in the money market to earn areturn of 9% per year. The money market may be assumed to be anefficient market.

Quadrant's cost of capital is 12% per year.

Required:

(a)Calculate the expected Net Present Value for each project, and rank the projects.

(b)Assuming the projects aredivisible, calculate the profitability index for each project, and rankthe projects to determine how the money would be best invested. Explainbriefly why the rankings differ from that in (a) above.

(c)Now assume the projects are indivisible. Provide advise on how the funds are best invested.

(d)Explain how uncertainty and risk could be considered in the investment process.

5. Ceder Co

Ceder Co has details of two machines which could fulfil thecompany's future production plans. Only one of these machines will bepurchased.

The 'standard' model costs $50,000, and the 'de-luxe' $88,000,payable immediately. Both machines would require the input of $10,000working capital throughout their working lives, and both machines haveno expected scrap value at the end of their expected working lives offour years for the standard machine and six years for the de-luxemachine.

The forecast pre-tax operating net cash flows associated with the two machines are:

The de-luxe machine has only recently been introduced to the marketand has not been fully tested in operating conditions. Because of thehigher risk involved, the appropriate discount rate for the de-luxemachine is believed to be 14% per year, 2% higher than the discount ratefor the standard machine.

The company is proposing to finance the purchase of either machine with a term loan at a fixed interest rate of 11% per year.

Taxation at 35% is payable on operating cash flows one year inarrears, and capital allowances are available at 25% per year on areducing balance basis.

Required:

(a)to calculate for both the standard and the de-luxe machine:

(i)payback period

(ii) net present value

(b)Recommend, with reasons, which of the two machines Ceder Co should purchase.

(c)If Ceder Co were offered theopportunity to lease the standard model machine over a four-year periodat a rental of $15,000 per year, not including maintenance costs,evaluate whether the company should lease or purchase the machine.