Question

Network Streaming Systems (NSS) Ltd is a video production company and currently rents the building in which its production equipment is located at an annual cost of £150,000, including all service charges.

The company is considering purchasing an alternative building in which to undertake its video business. These alternative premises are due to be demolished by the local council in 4 years’ time to make way for a new road. It is known that the Council will purchase the building at that time at its book value of £100,000. Because of the instability caused by the Council’s plans, NSS can purchase the building at a knock-down price of £250,000. Otherwise, since the building is located in a prime residential area, the land on which the building stands would be worth £1.8 million. Currently the building is in a state of disrepair, but a structural survey which has already been undertaken by NSS costing £3,000, recommends that the building must be upgraded at a cost of £50,000 before NSS moves in.

The annual heating and lighting expenses on the new building will be £40,000, but NSS will save the annual rents on its current premises. The removal costs of moving its equipment into the new building, and the cost of moving out again in four years’ time will be £25,000 on each occasion.

NSS pays corporation tax on its profits at 30%, and the tax authorities allow NSS to offset its corporate tax liabilities by using straight line depreciation on its fixed assets. You may assume that NSS has sufficient taxable profits to take full advantage of any tax shields from purchasing the building. NSS applies an opportunity cost of capital of 10 per cent to all future cash flows. Assume all annual cashflows occur at the end of the year to which they relate.

1. (a) Determine the free cash flow in each year from the investment in the new building, explaining your treatment of costs and depreciation allowances.

   (10 marks)

2. (b) What is the project NPV? (2 marks)

3. (c) NSS approaches you for advice on whether it should purchase the new building, and asks for your opinion on payback, IRR, and accounting rate of return as methods of investment appraisal. Advise NSS by comparing and contrasting the four alternative investment criteria. (8 marks)

4. (d) Suppose that there is a small probability that the Council might change its decision to build a road, allowing the owner to sell the land for residential development. Outline how this would change your valuation of the project.

   (5 marks)

Answer 1

Annual rent paid by the company= $1,50,000

Cost of the alternative building : Purchase price ($2,50,000) + Upgradation cost ($ 50,000) = $3,00,000

Annual heating and lightning exp = $ 40,000

Moving in and out exp for equipments = $ 25000 each time

Annual depreciation exp = $3,00,000/4 = $ 75,000

Corporate tax rate = 30%

(a) Determine the free cash flow in each year from the investment in the new building, explaining your treatment of costs and depreciation allowances :

Cash outflow in year 0 = Cost of alternative building ($ 3,00,000) + Expenses for removal of equipment ($ 25000)

= $ 3,25,000

Cash inflow for year 1,2,and 3 = Saving of rent ($150000)-Annual heating and lightning exp ($40,000)+Tax sheild on depreciation ($75,000*0.30)-Loss of tax on rent exp (1,50,000*0.30)

= 1,50,000-40,000+22,500-45,000=$87,500

Cash inflow for year 4 = same cashflow as for year 1,2, and 3 +sale of building ($1,00,000) - expenses on removal of equipment ($25,000) = 87,500+1,00,000-25,000 = $1,62,500

(b) What is the project NPV?

NPV =

= 3589.2357$

(c) NSS approaches you for advice on whether it should purchase the new building, and asks for your opinion on payback, IRR, and accounting rate of return as methods of investment appraisal. Advise NSS by comparing and contrasting the four alternative investment criteria.

As the NPV of the project is positive , the company should accept the proposal of purchasing new building.

• Payback is the number of years it takes to earn intial investment ( payback period only considers undiscounted cash infow).In this case payback period is 3 + 2,62,500-3,00,000/1,62,5000 = 3.23 years
• IRR is the rate at which NPV will be Zero.In this case NPV is positive , IRR will be less than 10 %.
• Acconting rate of return considers avg net profit and avg investment instead of cash inflow and outflow.

(d) Suppose that there is a small probability that the Council might change its decision to build a road, allowing the owner to sell the land for residential development. Outline how this would change your valuation of the project.

Then the client would have to pay $ 1.8 million insted of $3,00,00.In that case the proposal would not be profitable.