The net present value method Rage Limited is considering two capital investment projects. The details are outlined as follows:

Question

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	[latex]\underline{100} [/latex]	[latex]\underline{100} [/latex]

Estimated net cash flows:

Year: 1	20	10
2	80	40
3	40	40
4	–	40
5	[latex]\underline{ –} [/latex]	[latex]\underline{20} [/latex]
[latex]\underline{\underline{140} }[/latex]		[latex]\underline{\underline{150} }[/latex]

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.

Accepted Answer

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	–	–	[latex]\underline{ –} [/latex]	20 000	0.6209	[latex]\underline{12 418} [/latex]
Total present value			114 346			111 937
Less: initial cost			[latex]\underline{100 000} [/latex]			[latex]\underline{100 000} [/latex]
Net present value			[latex]\underline{\underline{14 346} }[/latex]			[latex]\underline{\underline{11 937} }[/latex]

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.

Question 19.4: The net present value method Rage Limited is considering two...

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Year: 1	20	10
2	80	40
3	40	40
4	–	40
5	$\underline{ –}$	$\underline{20}$
$\underline{\underline{140} }$		$\underline{\underline{150} }$