Tom is the owner of a business that designs, manufactures and fits kitchens and bathrooms. Business is currently good and Tom is considering whether to expand the company.

Tom is considering two options.

Option A involves leasing a neighbouring industrial unit which has recently become vacant. This is convenient and will allow a seamless transition to bigger premises. The industrial unit will need some alterations and fitting out, so it is fit for purpose.

The total cost of the works needed, including the installation of additional machinery and the construction of showrooms is estimated to cost 140,000. The industrial unit is on a 10 year lease (the lease cost is included in the 140,000 costs above), and Tom is working on the assumption that after 10 years the lease will need to be renewed and the machinery and equipment replaced. There is not expected to be any residual value left in the old machinery and equipment after 10 years.

Option B is more ambitious. Tom could take on a unit at a new industrial estate recently opened, several miles away. This is a much larger unit, and will allow Tom to expand his output even further, should he need to in the future.

Tom will again be tied into a 10 year lease, and the cost of option B is likely to be 320,000. Once more it is assumed that machinery and equipment will need to be replaced at the end of the 10 year period and that there will be no residual value.

Tom thought it prudent to conduct a feasibility study on both options and either looks suitable. The feasibility study cost 6000.

Projected annual income and costs are detailed below:

	Option A	Option B
	Neighbouring Unit	Unit on new estate
Income	170,000	270,000
Variable costs	90,000	160,000
Fixed costs (including depreciation)	30,000	50,000

Continued...

Required

(a)

Explain how you would consider the treatment of the 6,000 feasibility costs in this scenario.

(2 marks)

(b)

Calculate the Payback and the Net Present Value (NPV) of the two proposals. Use a discount rate of 8% for the NPV calculation.

(12 marks)

(c)

Identify the advantages and short comings of the Payback and NPV techniques as ways of evaluating capital projects.

(10 marks)

(d)

Explain how the internal rate of return is calculated, how it is used, and whether it is a suitable technique to be used in the investment decision given in the question.

(8 marks)

(e)

Which option should be accepted? Consider both financial and non-financial factors in coming to your decision.

(8 marks)

Total 40 marks