Question

Westcott–Smith is a privately held investment management company. Two other investment counseling companies, which want to be acquired, have contacted Westcott–Smith about purchasing their business. Company A’s price is £2 million. Company B’s price is £3 million. After analysis, Westcott–Smith estimates that Company A’s profitability is consistent with a perpetuity of £300,000 a year. Company B’s prospects are consistent with a perpetuity of £435,000 a year. Westcott–Smith has a budget that limits acquisitions to a maximum purchase cost of £4 million. Its opportunity cost of capital relative to undertaking either project is 12 percent.

A) Determine which company or companies (if any) Westcott–Smith should purchase according to the NPV rule.

B) Determine which company or companies (if any) Westcott–Smith should purchase according to the IRR rule.

C) State which company or companies (if any) Westcott–Smith should purchase. Justify your answer.

Answer 1

A) Determine which company or companies (if any) Westcott–Smith should purchase according to the NPV rule.

NPV of company A = (Profits per year / cot of capital) - Price = 300000 / 12% - 2000000 = 500000

NPV of company B = (Profits per year / cot of capital) - Price = 435000 / 12% - 3000000 = 625000

Select Company B as its NPV is higher than company A

B) Determine which company or companies (if any) Westcott–Smith should purchase according to the IRR rule.

IRR of Company A = Annual income / Price = 300000 / 2000000 = 15%

IRR of Company B = Annual income / Price = 435000 / 3000000 = 14.50%

Select Company A as its IRR is higher than company B

C) State which company or companies (if any) Westcott–Smith should purchase. Justify your answer.

Profitability Index of Company A = 1 + (NPV / price) = 1 + (500000/2000000) = 1.25

Profitability Index of Company B = 1 + (NPV / price) = 1 + (625000/3000000) = 1.21

the company should invest in a project which offers higher return for their investment thus investing in a higher PI company will result in higher present value

Thus invest in Company A