Question 4.SE.1: The directors of Mylo Ltd are currently considering two mutu...
The directors of Mylo Ltd are currently considering two mutually exclusive investment projects. Both projects are concerned with the purchase of new plant. The following data are available for each project:
| Project 1 £000 |
Project 2 £000 |
|
| Cost (immediate outlay) | 100 | 60 |
| Expected annual operating profit (loss): | ||
| Year 1 | 29 | 18 |
| 2 | (1) | (2) |
| 3 | 2 | 4 |
| Estimated residual value of the plant | 7 | 6 |
The business has an estimated cost of capital of 10 per cent. It uses the straight-line method of depreciation for all non-current assets, when calculating operating profit. Neither project would increase the working capital of the business. The business has sufficient funds to meet all capital expenditure requirements.
Required:
(a) Calculate for each project:
(i) The net present value.
(ii) The approximate internal rate of return.
(iii) The payback period.
(b) State which, if either, of the two investment projects the directors of Mylo Ltd should accept and why.
Mylo Ltd
(a) The annual depreciation of the two projects is:
Project 1:\frac{ (£100,000 − £7,000)}{3 }= £31,000
Project 2: \frac{(£60,000 − £6,000)}{3 }= £18,000
Project 1
(i) Net present value
| Year 0 £000 |
Year 1 £000 |
Year 2 £000 |
Year 3 £000 |
|
| Operating profit(loss) | 29 | (1) | 2 | |
| Depreciation | 31 | 31 | 31 | |
| Capital cost | (100) | |||
| Residual value | \underline{ } | \underline{ } | \underline{ } | \underline{ 7} |
| Net cash flows | \underline{ (100) } | \underline{ 60 } | \underline{30 } | \underline{40} |
| 10% discount factor | 1.000 | 0.909 | 0.826 | 0.751 |
| Present value | (100.00) | 54.54 | 24.78 | 30.04 |
| Net present value | \underline{ 9.36 } |
(ii) Internal rate of return
Clearly the IRR lies above 10%; try 15%:
| 15% discount factor | 1.000 | 0.870 | 0.756 | 0.658 |
| Present value | (100.00) | 52.20 | 22.68 | 26.32 |
| Net present value | \underline{ 1.20} |
Thus the IRR lies a little above 15%, perhaps around 16%.
(iii) Payback period
To find the payback period, the cumulative cash flows are calculated:
| Cumulative cash flows | (\underline{ 100 }) | (\underline{ 40 }) | (\underline{ 10 }) | \underline{ 30} |
| Thus the payback will occur after 3 years if we assume year-end cash flows. | ||||
Project 2
(i) Net present value
| Year 0 £000 |
Year 1 £000 |
Year 2 £000 |
Year 3 £000 |
|
| Operating profit(loss) | 18 | (2) | 4 | |
| Depreciation | 18 | 18 | 18 | |
| Capital cost | (60) | |||
| Residual value | \underline{ } | \underline{ } | \underline{ } | \underline{6} |
| Net cash flows | \underline{ (60) } | \underline{ 36 } | \underline{16 } | \underline{28} |
| 10% discount factor | 1.000 | 0.909 | 0.826 | 0.751 |
| Present value | (60.00) | 32.72 | 13.22 | 21.03 |
| Net present value | \underline{ 6.97 } |
(ii) Internal rate of return
Clearly the IRR lies above 10%; try 15%:
| 15% discount factor | 1.000 | 0.870 | 0.756 | 0.658 |
| Present value | (60.00) | 31.32 | 12.10 | 18.42 |
| Net present value | \underline{ 1.84} |
Thus the IRR lies a little above 15%; perhaps around 17%.
(iii) Payback period
The cumulative cash flows are:
| Cumulative cash flows | (60) | (24) | (8) | 20 |
| Thus, the payback will occur after 3 years (assuming year-end cash flows). | ||||
b) Presuming that Mylo Ltd is pursuing a wealth-enhancement objective, Project 1 is preferable since it has the higher NPV. The difference between the two NPVs is not significant, however.