Question 15.9: Lew Rolls plc is an international group that manufactures an...
Lew Rolls plc is an international group that manufactures and distributes bathroom fittings to major building supply retailers and DIY chains. The board of Rolls is currently considering four projects to work with four different customers to develop new bathroom ranges (toilet, bidet, bath, basin and
shower).
Rolls has a limit on funds for investment for the current year of £24m. The four projects represent levels of ‘luxury’ bathrooms. The product ranges are aimed at different markets. The lengths of time to bring to market, lives of product and timings of cash flows are different for each product range.
The Super bathroom project will cost £3m and generate £5m net cash flows spread equally over five years.
The Superluxury bathroom project will cost £7m and generate £10m net cash flows spread equally over five years.
The Executive bathroom project will take a long time to start paying back. It will cost £12m and generate £21m net cash flows, zero for the first two years and then £7m for each of the next three years.
The Excelsior bathroom project will cost £15m and generate £10m net cash flows for two years.
For ease of calculation it may be assumed that all cash flows occur on the last day of each year.
Projects may be undertaken in part or in total in the current year, and next year there will be no restriction on investment. Lew Rolls plc’s cost of capital is 10%.
You are required to:
(i) calculate the NPV for each project
(ii) calculate the approximate IRR for each project
(iii) advise on the acceptance of these projects on the basis of NPV or IRR or any other method of ranking the projects.
(iv) What are the advantages of the appraisal method you have adopted for Lew Rolls plc?
(v) What other factors should be used in the final evaluations before the recommendations are implemented?
(i)
| Super | Superlux | Exec | Excel | |||||||||||
| 10% | 20% | 10% | 20% | 10% | 20% | 10% | 20% | 10% | 20% | |||||
| Year | DF | DF | CF | DCF | DCF | CF | DCF | DCF | CF | DCF | DCF | CF | DCF | DCF |
| £m | £m | £m | £m | £m | £m | £m | £m | £m | £m | £m | £m | £m | £m | |
| 0 | 1.00 | 1.00 | -3 | -3 | -3 | -7 | -7 | -7 | -12 | -12 | -12 | -15 | -15 | -15 |
| 1 | 0.91 | 0.83 | 1 | 0.91 | 0.83 | 2 | 1.82 | 1.66 | 0 | 0 | 0 | 10 | 9.10 | 8.30 |
| 2 | 0.83 | 0.69 | 1 | 0.83 | 0.69 | 2 | 1.66 | 1.38 | 0 | 0 | 0 | 10 | 8.30 | 6.90 |
| 3 | 0.75 | 0.58 | 1 | 0.75 | 0.58 | 2 | 1.50 | 1.16 | 7 | 5.25 | 4.06 | 0 | 0 | 0 |
| 4 | 0.68 | 0.48 | 1 | 0.68 | 0.48 | 2 | 1.36 | 0.96 | 7 | 4.76 | 3.36 | 0 | 0 | 0 |
| 5 | 0.62 | 0.40 | \underline{\qquad 1} | \underline{0.62} | \underline{0.40} | \underline{\qquad 2} | \underline{1.24} | \underline{0.80} | \underline{\qquad 7} | \underline{4.34} | \underline{2.80} | \underline{\qquad 0} | \underline{\qquad 0} | \underline{\qquad 0} |
| Total | \underline{\qquad 2} | \underline{0.79} | \underline{-0.02} | \underline{\qquad 3} | \underline{0.58} | \underline{-1.04} | \underline{\qquad 9} | \underline{2.35} | \underline{-1.78} | \underline{\qquad 5} | \underline{2.40} | \underline{0.20} | ||
(ii)
Calculation of IRR
From the table above calculate the IRR for each of the projects using interpolation or extrapolation as shown in Figures 15.3 and 15.4 in Chapter 15 to obtain:
| Super | Superlux | Exec | Excel | |
| IRR | 19.8% | 13.6% | 15.7% | 20.9% |
| Ranking of projects (highest IRR ranked 1st) | 2 | 4 | 3 | 1 |
(iii)
| Net present value | ||||
| NPV of each project | £790,000 | £580,000 | £2,350,000 | £2,400,000 |
| NPV per £ invested | £0.263 | £0.083 | £0.196 | £0.160 |
| Ranking | 1 | 4 | 2 | 3 |
NPV per £ invested is the more reliable evaluation method for appraisal of this project therefore, given the £24m total investment constraint, the decision should be to invest:
| NPV per
£ invested |
NPV | ||
| £m | £ | ||
| Super | 3 | £0.263 | 790,000 |
| Exec | 12 | £0.196 | 2,350,000 |
| Excel | 9 | £0.160 | 1,440,000 |
| Superlux | 0 | £0.083 | \underline{\qquad 0} |
| Optimum total NPV | \underline{£4,580,000} |
If IRR rankings were used to make the investment decision:
| £m | NPV per
£ invested |
NPV | |
| £ | |||
| Super | 15 | £0.160 | 2,400,000 |
| Exec | 3 | £0.263 | 790,000 |
| Excel | 6 | £0.196 | 1,175,000 |
| Superlux | 0 | £0.083 | \underline{\qquad 0} |
| Total NPV | \underline{£4,365,000} | ||
| which is not optimal |
(iv) and (v)
You should refer to the relevant sections in Chapter 15 to check your solutions.
