Task 1
(I)
A plc is an investment organisation which is considering 2 potential new investments. These are mutually exclusive options in that the acceptance of any one investment would prevent investment in the other.
The organisation uses an after-tax weighted average cost of capital (WACC) of 14%.
Details of the two investments are as follows:
Investment A has an immediate cash outflow of £33,000 and this would be followed by cash inflows of £20,000 at the end of year 1, £20,000 at the end of year 2, £11,000 at the end of year 3 and £11,000 at the end of year 4.
Investment B requires an immediate cash outflow of £30,000 and would be followed by cash inflows of £12,000 at the end of year 1, £10,000 at the end of year 2, £20,000 at the end of year 3 and £20,000 at the end of year 4.
For both investments, the initial outflows attract a first year taxation capital allowance of 35% based on the initial investment amount, followed by writing down allowances of 35% of the tax written down value for years 2 and 3. Each investment will be disposed of at the end of year 4 with a nil residual value. The capital allowance to be claimed in year 4 for both investments will therefore be a balancing allowance which will reduce the taxation written down value to zero.
A plc pays corporation tax at the rate of 25% of its taxable profits after allowing for capital allowances. Assume that taxation in respect of year one profits is paid at the end of year two.
Required
Calculate the net present values of each of the proposed investments and recommend with justifications which of the two investments, if any, should be selected
The management of A plc considers to use bank loan, equity, debt or leasing to finance the investment selected in (a) above. Please identify and appraise the sources of funds available to A plc, and make proposals for obtaining funds if A plc is (i) a highly geared organisation; and (ii) a low geared organisation.
Post investment audit compare the prediction of investment costs and outcomes made at the time of project was selected to the actual results. What recommendation would you suggest on a post audit appraisal on the investment decision made in (a) above if the project selected has an initial cash outflow of 3% above budget and the annual cash inflow 5% under budget.
(II) Prince Wales Hospital, a government hospital, needs to purchase a new X-ray machine to replace the existing machine. The hospital spent $50,000 in the last few months on a technical feasibility study for the replacement. The historical acquisition cost, net book value, and current disposal value of the existing machine are $400,000, $50,000, and $3,790 respectively.
The cost of the new machine is $372,890. The new machine is expected to have a five-year useful life and a disposal value of zero at the end of five years. The Hospital is using straight line depreciation for all machines. As the new machine uses the latest technology and it is new to the market, annual revenue of $80,000 is estimated for the new machine on the basis of the cash generating capability of the existing machine. In addition, it needs to increase the investment in working capital from the current level of $100,000 to $110,000 immediately.
The new machine is faster and easier to operate, and it will decrease labour cost and operating costs. The new machine is expected to have annual cash saving of $20,000.
Required
Select appropriate and relevant financial information for use in the process of making strategic decisions on investment. Explain.
Calculate payback, IRR, and accounting rate of return of the investment and make recommendation with justifications on the proposal. The policy of the Hospital is to have a required rate of return of 8% for all projects.