Revision Progress Test 1 Investment Appraisal

Answer 1 (a)(i) The discount rate to be used in the NPV calculations is the after-tax cost of borrowing = (5.5% + .!%) x ( " #$%) = 5% NPV of purchase
%ear Purchase cost * +roceeds -. tax benefits / 2aintenance Net cash flow 34 5 5% PV NPV = $ ) (5,$$$.$$) ) & ) #!5.$$ (($.$$) # 5.$$ $.1$! &05.! # ) &0 .&5 (($.$$) && .&5 $.0(' 1 . ( ' ) & $.1' ( $$.$$) $.1' $.0&# 1 .#$ 5 ) &,$$$.$$ 50.&$ ( $$.$$) &,$50.&$ $.!0' ,( #.(# ( ) ( &5.#1) ( &5.#1) $.!'( (1#.5')

(5,$$$.$$) .$$$ (5,$$$.$$) (&,1(0.0()

(($.$$) (($.$$) $.15& (5!. &)

/ -a+ital allowances %ear & # ' 5

/3. 5,$$$.$$ #,!5$.$$ &,0 &.5$ &, $1.#0 ,50&.$#

x &5% = x &5% = x &5% = x &5% = - &,$$$

&5% allowance ,&5$.$$ 1#!.5$ !$#. # 5&!.#' (' !.1!) 6alancing charge

x #$% = x #$% = x #$% = x #$% = x #$% =

Tax benefits #!5.$$ &0 .&5 & $.1' 50.&$ ( &5.#1)

NPV of lease payments

%ear 7ease +a89ent Tax sa:ed Net cash flow 34 5 5% PV NPV = $ ) (05$.$$) (05$.$$) .$$$ (05$.$$) (&,0 &.'0) ) (05$.$$) (05$.$$) $.15& (0$1.&$) & ) (05$.$$) &55.$$ (515.$$) $.1$! (5#1.(!) # ) (05$.$$) &55.$$ (515.$$) $.0(' (5 '.$0) ' ) (05$.$$) &55.$$ (515.$$) $.0&# ('01.(1) 5 ) &55.$$ &55.$$ $.!0' 11.1& ( ) &55.$$ &55.$$ $.!'( 1$.&#

The net benefit of leasing is ) 5(.#0 therefore 7;; should lease rather than +urchase the 9achiner8. (a)(ii)

The NPV of lease payments can increase by $1 !"#$ before the NPV of the lease benefits is e%ual to &ero. The sensiti:it8 of the NPV of the benefits of leasing to the :alue of the lease +a89ents is<
5(.#! = 5.5(% &,0 &.'0

The lease +a89ents can therefore increase to )05$ + 5.5(% = )01! therefore the NPV of the lease costs is e=ual to the NPV of the +urchase costs. The highest lease rental that 7;; would be li>el8 to acce+t is therefore )01!. (b)

Non-financial factors affecting 7;;?s choice ( ) @is> of obsolescence .n o+erating lease 9a8 +ro:ide greater flexibilit8 to re+lace or u+grade the 9achiner8 should it beco9e obsolete during the +eriod of the lease. Aowe:er, this does de+end on the ter9s of the lease agree9ent and it 9a8 be that the +urchase o+tion offers greater flexibilit8 if the leases are for a fixed 9ini9u9 ter9 of fi:e 8ears.
&

(&)

(#)

2aintenance 7ee 9a8 +refer to be res+onsible for ser:icing and 9aintenance of the asset to ensure a business critical asset is not out of action for a da9aging +eriod of ti9e. This would 9a>e the +urchase or finance lease o+tions 9ore attracti:e than an o+erating lease. Bseful life and residual :alue The useful life and residual :alue of the 9achiner8 are both uncertain and changes 9a8 i9+act on the choice of alternati:es. 4or exa9+le, a longer ti9e +eriod for the 9achine to be used would 9a>e the +urchase and finance lease o+tions 9ore attracti:e. Cf the residual :alue of the 9achiner8 in fi:e 8ears? to9e is less than ex+ected, it 9a>es the +urchase o+tion e:en less attracti:e.

Answer ' (a) (iscount rate to be use) in the investment )ecision The ris> adDusted discount rate is found fro9 the -.P2, using an esti9ate of the beta factor suitable for this t8+e of in:est9ent. The beta can be ta>en fro9 the =uoted co9+etitor of -*-, and adDusted to re9o:e the effect of this co9+etitor?s gearing, since -*- is ungeared.
Vd ( T ) Ve a = e + d ( Ve + V d ( T ) ) ( Ve + V d ( T ) ) ' ( $.#) = .# + $. 5 ' + ( $.#) ' + ( $.#) = . &1 Bsing -.P2
K e = R f + ( Rm R f ) = 5% + . &1 ( &% 5%) = &.1%

Nearest to %, = #% (b)
%ear $ & #

E$$$
Fales re:enue (/ ) -osts 4uel costs (/&) Fterling costs (increase #%) Cncre9ental ad9in o:erheads .d:ertising and +ro9otion Total costs Cnco9e less costs Tax at #$% Tax credit on ca+ital allowances (/#) Cn:est9ent Net cash flow #% discount factors (fro9 (a)) ( 1,($0) ( 1,($0) ( 1,($0)

E$$$
#,#!0 &,05' &,10! &5$ #5$ (,'' (,1#! (&,$0 ) ,'! (,#&! $.005 5,511

E$$$
',0#& &,1(1 #,$!! &5$ #5$ (,('( 0, 0( (&,'5() , $# (,0## $.!0# 5,#5$

E$$$
5, &0 #,$00 #, (1 &5$ #5$ (,05! 0,&! (&,'0 ) &( $, 51 (,& $ $.(1# ,&#'

NPV = E&,5!5 (in thousands)

'

*or+ings / ;x+ected sales re:enue 7oad $$% 0$% 5$% '$% Prob. $. $ $.5$ $.#$ $. $ .$$ 2axi9u9 +assengers ;x+ected +assengers %ear ;x+ected +assengers Tri+s +er 8ear (( x '0) 4are E(increase &% +a) Total inco9e (E$$$) ;V $% '$% 5% '% (1% &&$ 5 .0 & (5 &00 # &. & ',0#& Prob. $. 5 $.($ $.&$ $.$5 .$$ ;V 5% '0% $% &% !5% &&$ (5 # (5 &00 # 0.#( 5, &0

5 .0 &00 #$( #,#!0

/& 4uel costs ;xchange rates Bsing +urchasing +ower +arit8 theor8 ;nd of 8ear ;xchange rate )GE $ .5#$ ( .5# x .$'G .$#) .5'5 & ( .5'5 x .$'G .$#) .5($ # ( .5($ x .$'G .$#) .5!5 %ear 4uel costs ()$$$) (increase 5% +a) ;xchange rates 4uel costs (E$$$) & ',(# .5($ &,1(1 # ',0(# .5!5 #,$00

',' $ .5'5 &,05'

/# -a+ital allowances
5

-ost of +lane (8ear $) @esale :alue (8ear #) ;nd of 8ear $ & # (balancing figure)

)9 #$,$$$ (,$$$ /3V E$$$ 1,($0 ',!$( ,$&1 $, 51

;x. @ate .5#$ .5!5 -. (&5%) E$$$ ',1$& #,(!! 0!$

E9 1,($0 $, 51 Tax #$%

,'! , $# &(

Non-rele:ant costs The 9ar>et research and +urchase negotiations costs are excluded fro9 the a++raisal because the8 are sun> costs. The E5$,$$$ re-allocation of current head office costs is excluded because it is not directl8 attributable to the a++raisal. Recommen) 6ased on the calculations, the co9+an8 should +roceed with the in:est9ents. Aowe:er the abo:e 9ethod suffers fro9 li9itations< Those of -.P2 are outlined abo:e, but the calculations appear to in)icate that there is a safety margin, and that the internal rate of return of the in:est9ent will be a few +ercentage +oints higher than #%. The figures use) are e,pecte) values, an a:erage of a nu9ber of +ossible outco9es. Ct is +ossible that actual results may vary significantly fro9 these. Cnstead of basing their decision on one calculation, -*- should carr8 out a :ariet8 of calculations, certainl8 consi)ering the best an) worst possible outcomes it could face.

-ar+ing .cheme
-ar+s (a) -alculation of ungeared (asset) beta -alculation of discount rate using -.P2 (b) -alculation of sales re:enue -alculation of fuel costs -alculation of sterling costs Cncre9ental ad9in o:erheads .d:ertising and +ro9otion Tax ex+enses Tax credit on ca+ital allowance Cn:est9ent @eco99endation # & &5 $.5 .5 # ( # & # '