Question 5.SE.1: Lee Caterers Ltd is about to make an investment in new kitch...
Lee Caterers Ltd is about to make an investment in new kitchen equipment. It is considering whether to replace its existing kitchen equipment with cook/freeze or cook/chill technology. The following cash flows are expected from each form of technology:
| Cook/chill £000 |
Cook/freeze £000 |
|
| Initial outlay | (200) | (390) |
| 1 year’s time | 85 | 88 |
| 2 year’s time | 94 | 102 |
| 3 year’s time | 86 | 110 |
| 4 year’s time | 62 | 110 |
| 5 year’s time | – | 110 |
| 6 year’s time | – | 90 |
| 7 year’s time | – | 85 |
| 8 year’s time | – | 60 |
The business would expect to replace the new equipment purchased with similar equipment at the end of its life. The cost of capital for the business is 10 per cent.
Required:
Which type of equipment should the business invest in? Use both approaches to dealing with this problem, which were described in the chapter, to support your conclusions.
Lee Caterers Ltd
The first step is to establish the NPV for each project:
(a) Cook/chill project
| Cash flows £000 |
Discount rate 10% |
Present value £000 |
|
| Initial outlay | (200) | 1.00 | (200) |
| 1 year’s time | 85 | 0.91 | 77.4 |
| 2 year’s time | 94 | 0.83 | 78.0 |
| 3 year’s time | 86 | 0.75 | 64.5 |
| 4 year’s time | 62 | 0.68 | 42.2 |
| NPV 62.1 | |||
(b) Cook/freeze project
| Cash flows £000 |
Discount rate 10% |
Present value £000 |
|
| Initial outlay | (390) | 1.00 | (390) |
| 1 year’s time | 88 | 0.91 | 80.1 |
| 2 year’s time | 102 | 0.83 | 84.7 |
| 3 year’s time | 110 | 0.75 | 82.5 |
| 4 year’s time | 110 | 0.68 | 74.8 |
| 5 year’s time | 110 | 0.62 | 68.2 |
| 6 year’s time | 90 | 0.56 | 50.4 |
| 7 year’s time | 85 | 0.51 | 43.4 |
| 8 year’s time | 60 | 0.47 | 28.2 |
| NPV 122.3 | |||
Eight years is the minimum period over which the two projects can be compared. The cook/chill will provide the following NPV (in £000s) over this period:
NPV = £62.1 + \frac{£62.1}{(1 + 0.1)^{4}} = £104.6
This NPV of £104,600 is lower than the NPV for the cook/freeze project of £122,300 (see above). Hence, the cook/freeze project should be accepted.
Using the equivalent-annual-annuity approach we derive the following (£000s):
Cook/chill: £62.1 × 0.3155 = £19.59
Cook/freeze: £122.3 × 0.1874 = £22.92
This approach leads to the same conclusion as the earlier approach.