Question

QUESTION SIX

“Riverbend is a rapidly growing biotech company that has a required rate of return of 12%. It plans to build a new facility. The building will take two years to complete. The building contractor offered Riverbend a choice of three payment plans, as follows:                                             

                                                                                                   

Plan I Payment of £100,000 at the time of signing the contract and £5,000,000 upon completion of the building. The end of the second year is the completion date.                                          

                                                                                                   

Plan II Payment of £1,500,000 at the time of signing the contract and £1,500,000 at the end of each of the two succeeding years.                                                

                                                                                                   

Plan III Payment of £200,000 at the time of signing the contract and £1,400,000 at the end of each of the three succeeding years.”                        

Required:                                                   

                                                 

1. “Using the net present value method, calculate the comparative cost of each of the three payment plans being considered by Riverbend.”         

2. “Which payment plan should Riverbend choose? Explain.” (Maximum word count: 25)

                                                           

3. “Discuss the financial factors, other than the cost of the plan, and the non-financial factors that should be considered in selecting an appropriate payment plan” (Maximum word count: 100)

                                                 

Answer 1

Answer to a- Part 1

		Actual cashflow	Discounted cashflow @ 12%
In £	Year	Plan I	Plan II	Plan III	Plan I	Plan II	Plan III
Year 0	0	(100,000)	(1,500,000)	(200,000)	(100,000)	(1,500,000)	(200,000)
Year 1	1	-	(1,500,000)	(1,400,000)	-	(1,339,286)	(1,250,000)
Year 2	2	(5,000,000)	(1,500,000)	(1,400,000)	(3,985,969)	(1,195,791)	(1,116,071)
Year 3	3	-	-	(1,400,000)	-	-	(996,492)
	Total cost / NPV	(5,100,000)	(4,500,000)	(4,400,000)	(4,085,969)	(4,035,077)	(3,562,564)

Note 1 : The actual cashflow and discounted cashflow in year 0 is the same as no time has elapsed.

Note 2 : Following screenprint will help in understanding the discounting of cash flows.

Answer to a- Part 2

Riverband should choose plan III for the payment beacause the NPV of the cost is the lowest in plan 3 and also it leads to lesser cashflow in absolute terms as well (4.4 million against 4.5 or 5.1 million).

Answer to a- Part 3

Financial factors

1. Riveraband should check with the contract the mode of payment and if it involves any charges.
2. Riverband should draw out a contract in a way that offers legal protection to Riverband and indemnities in case the construction is not done in time and other situations.

Non-financial factors

1. Riverband should ensure with the contractor that no matter which payment option it chooses, it would not affect the quality of the construction in any way like material, labour, etc.
2. Riverband should also confirm with the contractor that the choice of plan does not impact the timeline of completion of the project.