Question 19.4: The net present value method Rage Limited is considering two...
The net present value method
Rage Limited is considering two capital investment projects. The details are outlined as follows:
| project | 1 | 2 |
| Estimated life | 3 years | 5 years |
| Commencement date | 1.1.01 | 1.1.01 |
| £000 | £000 | |
| Project cost at year 1 | \underline{100} | \underline{100} |
Estimated net cash flows:
| Year: 1 | 20 | 10 |
| 2 | 80 | 40 |
| 3 | 40 | 40 |
| 4 | – | 40 |
| 5 | \underline{ –} | \underline{20} |
| \underline{\underline{140} } | \underline{\underline{150} } | |
The company expects a rate of return of 10% per annum on its capital employed.
Required:
Using the net present value method of project appraisal, assess which project would be more profitable.
| Rage Ltd | ||||||
| Project appraisal: | ||||||
| Project 1 | Project 2 | |||||
| Year | Net cash flow |
Discount factor |
Present value |
Net cash flow |
Discount factor |
Present value |
| (1) | (2) | (3) | (4) | (5) | (6) | (7) |
| £ | 10% | £ | £ | 10% | £ | |
| 1 | 20 000 | 0.9091 | 18 182 | 10 000 | 0.9091 | 9 091 |
| 2 | 80 000 | 0.8264 | 66 112 | 40 000 | 0.8264 | 33 056 |
| 3 | 40 000 | 0.7513 | 30 052 | 40 000 | 0.7513 | 30 052 |
| 4 | – | – | – | 40 000 | 0.6830 | 27 320 |
| 5 | – | – | \underline{ –} | 20 000 | 0.6209 | \underline{12 418} |
| Total present value | 114 346 | 111 937 | ||||
| Less: initial cost | \underline{100 000} | \underline{100 000} | ||||
| Net present value | \underline{\underline{14 346} } | \underline{\underline{11 937} } | ||||
Tutorial notes
1 The net cash flows and the discount factor of 10% (i.e. the rate of return) were given in the question.
2 The discount factors may be obtained from the discount table in Appendix 2.
3 Column (4) has been calculated by multiplying column (2) by column (3).
4 Column (7) has been calculated by multiplying column (5) by column 6.
Both projects have a positive NPV but project 1 will probably be chosen in preference to project 2 because it has a higher NPV, even though its total net cash flow of £140,000 is less than the total net cash flow of £150,000 for project 2.