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.

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

(b) What is the project NPV?

(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.

(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.

Answer 1

a) See image for detailed cashflow working

b) NPV = Positive GBP 29,527.5

c) PBP =3.74 years. ITT = 14% and ARR = 53% Based on these 3, NSS should invest in the building

d) If there is a probability of the council changing its decision and the owner can sell land for residential development, that would affect both the present purchase value of the Building and the final resale value. Thus Initial investment and depreciation working will change.