Reference no: EM13863089

Pirates Limited owns two acres of derelict land near to the centre of a major city. The company has received an invoice for R50 000 from consultants that were given the task of analysing, investigating and designing some project proposals for the use of the land. The consultants outline the two best proposals to a meeting of the Pirates Limited board.

PROJECT 1

This proposal is to spend R150 000 levelling the site and then constructing a six-storey car park at an additional cost of R1 600 000. On the start date, the earthmoving company will be paid R150 000 and the construction company will be paid R1 400 000, with the balance payable 24 months later.

It is expected that the car park will be fully operational as from the completion date (365 days after the earthmovers first begin). The annual income from ticket sales will be R600 000 to an infinite horizon.

Operational costs, attendants, security and power will be R100 000 per annum. The consultants have also apportioned R60 000 of Pirates Limited's central overhead costs created by the London-based head office and the executive jet to this project.

The consultants present their analysis in terms of a commonly used measure of project viability, that of payback. This investment is not original; the CFO investigated a similar project two years previously and discovered that there were some costs which have been ignored by the consultants.

First, the local council will require a payment of R100 000 one year after the completion of the construction for its inspection services and a trading and environmental impact licence. Second, senior management will have to leave aside work on other projects, resulting in delays and reduced income from these projects amounting to R50 000 per year once the car park is operational. Also, the proposal is subject to depreciation of one-fiftieth (1/50) of the earthmoving and construction costs each year

PROJECT 2

This proposal is for a health club. An experienced company will, for a total cost of R9 million payable at the start of the project, design and construct the buildings and supply all the equipment. It will be ready for the Pirates Limited's use one year after construction begins.
Revenue from customers will be R5 million per annum and operating costs will be R4 million per annum. The consultants allocate R70 000 of central general head office overhead costs for each year from the start. After two years of operating the health club Pirates Limited will sell it for a total of R11 million.

Information not considered by the consultants for Project 2:

- The investment of R9 million includes R5 million in buildings not subject to depreciation.

- It also includes R4 million for equipment, 10% of which has to be replaced each year. This has not been included in the operating costs.

- A new executive will be needed to oversee the project from the start, costing R100 000 per annum. The consultants recommend that the board of Pirates Limited accept the second proposal and reject the first.

Assumptions:

1. If the site were sold with no further work carried out it would fetch R100 000.

2. No inflation or tax

3. The cost of capital for Pirates Limited is 10%.

4. All cash flows occur at year ends except those occurring at the start of the project.

REQUIRED:

2.1 Calculate the net present value of each project and state whether you would recommend Project 1 or 2.

2.2 Calculate the internal rate of return for each proposed project.