Question

Q: AYR Co. is considering two separate projects known as ‘Aspire’ and ‘Wolf’ which are quite different but each of which has the potential to increase AYR Co.’s market share. To date $120,000 has been spent on market research into the increase in demand that can be expected for each project. The next stage is to conduct a financial appraisal to determine which project should be taken forward as AYR Co. can only afford to fund one project at this time. Project Aspire: This project will require the acquisition of plant and machinery costing $2,250,000 which is payable immediately. This machinery will have a scrap value of $375,000 at the end of the 5 years. There is also $140,000 working capital to be used immediately. This amount has been taken from the company’s retained profits and will be repaid at the end of the project. Cash inflows are expected to be $650,000 in year 1 rising at a rate of 7.5% per annum for years 2 to 5 inclusive. Variable costs in year 1 are expected to be $27,000 per annum and are expected to rise at 6.75% per annum. Capital allowances are available on the plant and machinery as follows: Year 1 - 600,000 Year 2 - 390,000 Year 3 - 345,000 Year 4 - 300,000 Year 5 - 240,000 600,000 390,000 345,000 300,000 240,000 This project will expand the current product range and will appeal to existing and potential customers. Project Wolf: This project will require an immediate outlay of $2,250,000. This expenditure will not attract capital allowances. Annual cash inflows of $955,000 are expected to be constant for the life of the project. Material costs are expected to be $14,400 in the first year, rising at an annual inflation rate of 7.5% per annum. Other expenses are expected to be $18,000 in year 1 and these are expected to fall by 7.5% per annum over the life of the project. To undertake Project Wolf, factory space which is currently generating rental income will need to be used for the project. The rental income, which would not have been expected to change over the five-year period, is $75,000 per annum. T his project will take the company in a new direction appealing to a different type of customer. Additional financial information:  Corporation tax is paid at a rate of 20% and tax is payable one year in arrears.  The weighted average cost of capital is 10% and, unless otherwise stated, cash flows occur at the end of the year to which they relate.  A straight line method of depreciation at a rate of 20% is applied to all non current assets. The initial investment of $2.250m, for whichever project is chosen, is significant in terms of value for AYR Co. The board of directors is considering ways to finance the investment, and will choose between, increasing equity by issuing new ordinary shares, or taking on new debt in the form of a bank loan at a fixed rate of interest. AYR Co. is currently financed as follows: Capital Employed $million Equity holder funds 20 Long term debt 18 Total 38 Required: Prepare a report to the Directors of AYR Co. which includes the following. 1. A calculation of the Net Present Value (NPV), Internal Rate of Return (IRR) and Payback Period for projects Aspire and Wolf. Detailed calculations should be included as an appendix to the report. All cash flows should be rounded to the nearest $. 2. Analysis and evaluation of the investment project options as follows : i. A recommendation regarding which project (if any) to undertake; ii. Justifications for your recommendation including an evaluation of the investment appraisal techniques used in task 1 above. iii. A summary of other factors that should be considered and information that may be needed prior to making a final decision. 3. A discussion of the two sources of finance being considered by the board of AYR Co. Your report should include: i. A description of Equity and Debt. ii. An explanation of the costs of each source of finance. iii. An analysis of the effect the selection of the source of finance may have on AYR Co.’s weighted average cost of capital. iv. An assessment of the impact of the selection of finance on current and potential shareholders and lenders. WHAT IS THE TREATMENT OF: A straight line method of depreciation at a rate of 20% is applied to all non current assets. HOW IS THE DEPRECIATION OF 20% TO ALL NON-CURRENT ASSET TREATED IN PROJECT WOLF???????? GIVEN THE PROVIDED ANSWER.. HOW IS THIS REPRESENTED IN THE STATEMENT? HOW IS IT REPRESENTED IN THE STATEMENT???? PLEASE SHOW THE CALCULATIONS Expert Answer Preetika Preetika answered this Was this answer helpful? 0 0 80 answers By definition, Straight Line Basis calculates depreciation which is an accounting measure of the "loss" of value of an asset over time. In other words, depreciation represents the value an asset losses each time it is used. Depreciation is measured over a period of time -- called the "useful life of the asset." Each asset has an established useful life. In project wolf, a period of 5 years is taken, and hence, this is a case of straight line depreciation. In income statement, this present value of depreciation amount (= 20% of $2.25 mn = $0.45mn) will be declined every year from the income. Thus, whatever present value of net income you compute, you need to subtract present value of depreciation from this. Post this, you need to deduct the tax.

Answer 1

For project Wolf,

The only non- current asset is the one for which there is an expenditure of 2,250,000

This is the cost of the asset

Now depreciation is at the rate of 20% on a straight line basis

amount of depreciation on cost of the asset per year = 20% * cost of the asset

= 0.20 * 2,250,000 = $ 450,000

This is the amount of depreciation you have to include EACH YEAR while calculating net cash flow for each year

Refer to the image on how to include depreciation

You will include the cost of asset in present year that is 0th year as a cash outflow ( thata is why the negative amount )

but this is an intial investment

we do not use the entire asset in a single year that is why we include part of the cost of asset that will actually be used in that year in terms of depreciation, and since this is an expense ( the part of asset that is used up )

it is also negative

thus while calculating cash flows of the project each year, you will subtract the depreciation amount each year