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