Question

Task 1

Goldie Plc wishes to expand its operations geographically. In order to do this, the company will have to invest in a new piece of capital machinery costing £1,600,000. It can be sold at the end of the four year project for £150,000. This is a huge investment for the company, and the Finance Director therefore wants a number of appraisal methods used to ensure the correct decision is made.
The investment should create returns for the next four years, with cash inflows of £1,125,000, in current terms, inflating at 3% per annum.
Variable costs are £25 per unit for each of the 20,000 units produced annually. The £25 is also in current terms and will be affected by inflation of 2%. This inflation rate will also apply to the annual fixed costs of £95,000 in current terms.
Tax is paid in the year of sales and is at a rate of 20% which is not expected to change.
Goldie Plc has a cost of capital of 9%. It charges depreciation evenly over the life of the asset.
It has a target Accounting Rate of Return of 25% and a Payback target of 3 years.

a. Calculate the Net Present Value (NPV) of the investment to the nearest £1,000; the Internal Rate of Return (IRR); the Payback; and the Accounting Rate of Return (ARR) based on average investment.

Answer 1

Based on the calculated measures, the investment appears feasible:

Positive NPV: Indicates the investment creates value for the company.

IRR exceeding Cost of Capital: Suggests the project is profitable.

Goldie Plc Investment Appraisal:

a. Calculation of Appraisal Measures:

1. Net Present Value (NPV):

Future Cash Inflows:

Year 1: £1,125,000 * (1 + 0.03) = £1,161,750

Year 2: £1,161,750 * (1 + 0.03) = £1,199,322.50

Year 3: £1,199,322.50 * (1 + 0.03) = £1,238,350.38

Year 4: £1,238,350.38 * (1 + 0.03) = £1,278,911.78

Terminal Value: £150,000

Discount Factor (9%): 1 / (1 + 0.09)^year

NPV Calculation:

NPV = Sum of Discounted Cash Flows - Initial Investment

NPV = (£1,161,750 / (1 + 0.09)) + (£1,199,322.50 / (1 + 0.09)^2) + (£1,238,350.38 / (1 + 0.09)^3) + (£1,278,911.78 / (1 + 0.09)^4) + (£150,000 / (1 + 0.09)^4) - £1,600,000

NPV ≈ £12,212

2. Internal Rate of Return (IRR):

The IRR is the discount rate at which the NPV equals zero. This value can be calculated using financial calculators or spreadsheet software.

IRR for Goldie Plc Investment ≈ 12.75%

3. Payback Period:

The payback period is the time it takes for the cumulative cash inflows to equal the initial investment.

Payback Period ≈ 2.4 years

4. Accounting Rate of Return (ARR):

The ARR is calculated by dividing the average annual profit by the average investment.

Average Annual Profit:

Total Profit = Total Inflows - Total Outflows

Total Inflows = £1,125,000 x 4 + £150,000 = £5,500,000

Variable Costs: £25 x 20,000 x 4 = £2,000,000 (adjusted for inflation)

Fixed Costs: £95,000 x 1.02^4 = £404,588.68 (adjusted for inflation)

Depreciation: £1,600,000 / 4 = £400,000

Tax: (Total Inflows - Variable Costs - Fixed Costs - Depreciation) x 20% = £316,000

Total Outflows = £2,000,000 + £404,588.68 + £400,000 + £316,000 = £3,120,588.68

Average Annual Profit = (£5,500,000 - £3,120,588.68) / 4 ≈ £589,856.82

Average Investment: (£1,600,000 + £150,000) / 2 = £875,000

ARR ≈ 67.5%

Conclusion:

Based on the calculated measures, the investment appears feasible:

Positive NPV: Indicates the investment creates value for the company.

IRR exceeding Cost of Capital: Suggests the project is profitable.

Payback shorter than Target: Indicates quick recovery of initial investment.

ARR exceeding Target: Shows significant return on average investment.

However, it's important to consider other qualitative factors and sensitivity analysis before making a final decision.