Question

Q:

AYR Co. is considering two separate projects known as ‘Aspire’ and ‘Wolf’ which are qu... 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 noncurrent 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.

PLEASE PROVIDE THEANSWER TO:

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.

Answer 1

	PROJECT ASPIRE
		INITIAL CASH FLOW
		Market research expenses	($120,000)
		Plant and machinery	($2,250,000)
		Working capital	($140,000)
		Total Initial Cash flow	($2,510,000)
		Tax Rate=20%=0.2
		Annual Cash flow
		cash inflow in year2=1.075*cash inflow in year 1. Cashinflow in year (n+1)=1.075*(cash flow in year(n)
		Variable cost in year 2=1.0675*variable cost in year1, Variable cost in year (n+1)= 1.0675*variable cost in year(n)
			A	B	C=A+B	D=C*(1-0.2)	E	F=E*0.2	G=0.2*120000	H=G*0.2	I=D+F+H
		Year	Cash inflow	Variable cost	Income before	After tax	Capital allowance	Capital allowance tax shield	Depreciation of non current asset	Depreciation tax shield	Net after taxCash inflow
				Cash flow	Tax	Income
		1	$650,000	($27,000)	$623,000	$498,400	$600,000	$120,000	$24,000	$4,800	$623,200
		2	$698,750	($28,823)	$669,928	$535,942	$390,000	$78,000	$24,000	$4,800	$618,742
		3	$751,156	($30,768)	$720,388	$576,311	$345,000	$69,000	$24,000	$4,800	$650,111
		4	$807,493	($32,845)	$774,648	$619,718	$300,000	$60,000	$24,000	$4,800	$684,518
		5	$868,055	($35,062)	$832,993	$666,394	$240,000	$48,000	$24,000	$4,800	$719,194
						Total	$1,875,000
		Terminal cash flow:
		Scrap value	$375,000
		Release of working capital	$140,000
		Total terminal cash flow	$515,000
		Cost of capital=10%=0.1
		Present Value(PV) of cash flow=(Cash flow)/((1+0.1)^N)
		N=Year of cash flow
		Year wise cash flow and PV of cash flows are given below:
		N	J	K=J/(1.1^N)
		YEAR	Cash flow	PV of Cash flow	Cumulative cash flow
		0	($2,510,000)	-2510000	($2,510,000)
		1	$623,200	566545.4545	($1,886,800)
		2	$618,742	511357.0248	($1,268,058)
		3	$650,111	488438.0165	($617,947)
		4	$684,518	467535.0044	$66,571
	(719194+515000)	5	$1,234,194	766337.3714	$1,300,765
			Total	290212.8717
		Payback period=Period at which cumulative cash flow=0
		Payback period=3+(617947/684518)=	3.90	Years
		Net Present value(NPV)	$   290,213
		Internal Rate of return(IRR)	13.97%	(Using excel IRR function over cash flow)
		PROJECT WOLF
		INITIAL CASH FLOW
		Market research expenses	($120,000)
		Plant and machinery	($2,250,000)
		Total Initial Cash flow	($2,370,000)
		Tax Rate=205=0.2
		Annual Cash flow
		Variable cost in year 1=(14400+18000)=	$32,400
		Variable cost in year 2=1.075*variable cost in year1, Variable cost in year (n+1)=1.075* variable cost in year(n)
			A	B	C=A+B	D	E=C+D	F=E*(1-0.2)	G=0.2*2370000	H=G*0.2	I=F+H
		Year	Cash inflow	Variable cost	Income before	Opportunity cost of loss of rental income	Net Cash flow before tax	Net annual cash flow after tax	Depreciation of non current asset	Depreciation tax shield	Net after tax cash flow
				Cash flow	Tax
		1	$955,000	($32,400)	$922,600	($75,000)	$847,600	$678,080	$474,000	$94,800	$772,880
		2	$955,000	($34,830)	$920,170	($75,000)	$845,170	$676,136	$474,000	$94,800	$770,936
		3	$955,000	($37,442)	$917,558	($75,000)	$842,558	$674,046	$474,000	$94,800	$768,846
		4	$955,000	($40,250)	$914,750	($75,000)	$839,750	$671,800	$474,000	$94,800	$766,600
		5	$955,000	($43,269)	$911,731	($75,000)	$836,731	$669,385	$474,000	$94,800	$764,185
		Cost of capital=10%=0.1
		Present Value(PV) of cash flow=(Cash flow)/((1+0.1)^N)
		N=Year of cash flow
		Year wise cash flow and PV of cash flows are given below:
		N	H	I=H/(1.1^N)
		YEAR	Cash flow	PV of Cash flow	Cumulative cash flow
		0	($2,370,000)	-2370000	($2,370,000)
		1	$772,880	702618.1818	($1,597,120)
		2	$770,936	637137.1901	($826,184)
		3	$768,846	577645.3794	($57,338)
		4	$766,600	523598.1149	$709,262
		5	$764,185	474498.7613	$1,473,447
			Total	545497.6275
		Payback Period=3+(57338/766600)	3.07	Years
		Net Present value(NPV)	$   545,498
		Internal Rate of return(IRR)	18.67%	(Using excel IRR function over cash flow)
			ASPIRE	WOLF
		Payback Period(Years)	3.90	3.07
		Net Present value(NPV)	$   290,213	545,497.63
		Internal Rate of return(IRR)	13.97%	18.67%
	i)	PROJECT WOLF to be undertaken,
	ii)	NPV and IRR of Project WOLF are higher
	iii)	Other factors should be considered are risks, intangible factors like good will etc and sensitivity analysis