Question

Assignment

Osiadan Limited is a local real estate company that wishes to expand its operations. Six possible capital investments have been identified, but the company only has access to a total of $620,000. The projects are not divisible and may not be postponed until a future period. After the project’s end it is unlikely that similar investment opportunities will occur.

Expected net cash inflows (including salvage value)

Project	Year 1 $	Year 2 $	Year 3 $	Year 4 $	Year 5 $	Initial Outlay $
A	80,000	80,000	80,000	80,000	80,000	246,000
B	80,000	97,000	74,000			180,000
C	68,000	68,000	83,000	83,000		175,000
D	72,000	72,000	72,000	72,000		180,000
E	50,000	50,000	50,000	80,000	40,000	180,000
F	45,000	92,000	92,000			150,000

Project A and E are mutually exclusive. All projects are believed to be of similar risk to the company’s existing capital investments.

Any surplus funds may be invested in the money market to earn a return of 9% per year. The money market may be assumed to be an efficient market.

Osiadan Limited has the following information in its statement of financial position;

                                                            $’000

Ordinary shares of $0.5                      2,500

12% unsecured bonds                         1000                     

The ordinary shares are currently quoted at $1.3 each and the bonds are trading at $72 per $100 nominal. The ordinary dividend of $0.15 has just been paid with an expected growth rate of 10%. Corporation tax is currently 30%.

Required

1. Calculate the expected net present value for each of the six projects.
2. Calculate the expected profitability index associated with each of the six projects.
3. Rank the projects according to both of these investment appraisal methods. Explain briefly why these rankings differ.

2. Give reasoned advice to Osiadan Limited recommending which project should be selected.
3. A director of the company has suggested that using the company’s normal cost of capital might not be appropriate in a capital rationing situation. Explain whether you agree with the director.

Answer 1

Year	0	1	2	3	4	5	NPV	Profitability Index	Rank
A	(246,000.00)	80,000.00	80,000.00	80,000.00	80,000.00	80,000.00
B	(180,000.00)	80,000.00	97,000.00	74,000.00
C	(175,000.00)	68,000.00	68,000.00	83,000.00	83,000.00
D	(180,000.00)	72,000.00	72,000.00	72,000.00	72,000.00
E	(180,000.00)	50,000.00	50,000.00	50,000.00	80,000.00	40,000.00
F	(150,000.00)	45,000.00	92,000.00	92,000.00
Present Value Factor @10%	1.00	0.91	0.83	0.75	0.68	0.62
PV of A	(246,000.00)	72,727.27	66,115.70	60,105.18	54,641.08	49,673.71	57,262.94	1.23	IV
PV of B	(180,000.00)	72,727.27	80,165.29	55,597.30	-	-	28,489.86	1.16	V
PV of C	(175,000.00)	61,818.18	56,198.35	62,359.13	56,690.12	-	62,065.77	1.35	I
PV of D	(180,000.00)	65,454.55	59,504.13	54,094.67	49,176.97	-	48,230.31	1.27	II
PV of E	(180,000.00)	45,454.55	41,322.31	37,565.74	54,641.08	24,836.85	23,820.53	1.13	VI
PV of F	(150,000.00)	40,909.09	76,033.06	69,120.96	-	-	36,063.11	1.24	III

In the above table,Profitability Index is caluculated using formula - PV of Cash Inflows/Initial Investment. Ranks will not differ as they both relate with NPV method.

iii.a. Project C, D and F are to be selected and rest money should be invested.
iii.b. Capital Rationing situation,Company's normal cost of capital can be used only if the company expect that in future cost of capital will not change.Otherwise,Company shall incorporate future expectation of change in cost of capital.