In: Finance
DP Plc is considering whether to purchase a piece of land close
to a major city airport. The land
will be used to provide 600 car parking spaces. The cost of the
land is K6,000,000 but further
expenditure of K2,000,000 will be required immediately to develop
the land to provide access
roads and suitable surfacing for car parking. DP Plc is planning to
operate the car park for five
years after which the land will be sold for K10,000,000 at Year 5
prices. A consultant has prepared
a report detailing projected revenues and costs.
Revenues
It is estimated that the car park will operate at 75% capacity
during each year of the project. Car
parking charges will depend on the prices being charged by
competitors. There is a 40% chance
that the price will be K60 per week, a 25% chance the price will be
K50 per week and a 35%
chance the price will be K70 per week.
DP Plc expects that it will earn a contribution to sales ratio of
80%.
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Fixed Operating Costs
DP Plc will lease a number of vehicles to be used to transport
passengers to and from the airport. It is expected that the lease
costs will be K50,000 per annum.
Staff costs are estimated to be K350,000 per annum.
The company will hire a security system at a cost of K100,000 per
annum.
Inflation
All of the values above, other than the amount for the sale of the
land at the end of the five year period, have been expressed in
terms of current prices. The vehicle leasing costs of K50,000 per
annum will apply throughout the five years and is not subject to
inflation.
Car parking charges and variable costs are expected to increase at
a rate of 5% per annum starting in Year 1.
All fixed operating costs excluding the vehicle leasing costs are
expected to increase at a rate of 4% per annum starting in Year
1.
Other Information
The company uses net present value based on the expected values of
cash flow when evaluating projects of this type.
DP Ltd has a money cost of capital of 8% per annum.
DP’s Financial Director has provided the following taxation
information:
(1) Tax depreciation (Capital allowances) is not available on
either the initial cost of the land or the development costs.
(2) Taxation rate: 30% of taxable profits. Half of the tax is
payable in the year in which it arises, the balance is payable in
the following year.
All cash flows apart from the initial investment of K8,000,000
should be assumed to occur at the end of the year.
Required:
(a) Evaluate the project from a financial perspective. You should
use net present value as the basis of your evaluation and show your
workings in K’000. [14 Marks]
(b) Calculate the internal rate of return (IRR) of the project. [5
Marks]
The main reason why discounted cash flow methods of investment
appraisal are considered theoretically superior is that they take
account of the time value of money.
Required:
(c) Explain the THREE elements that determine the ‘time value of
money’ and why it is important to take it into consideration when
appraising investment projects. [6 Marks]
[TOTAL: 25 MARKS]