Question

Underwood Limited is considering investing in a new project, for which the following information is available:

Initial Investment                  £2,000,000

Life of Project                 5 years

Estimated annual cash flow £400,000 per annum

Residual Value                £150,000

The company has a cost of capital of 2%, but uses a 5% hurdle rate when assessing capital projects.

1. Stating clearly any assumptions you make, evaluate the financial viability of the investment by determining the project’s:

• Payback
• Accounting Rate of Return
• Net Present Value using the cost of capital
• Net Present Value using the hurdle rate

2. Based on the figures that you have determined in part a), do you recommend that the project should be allowed to continue? Justify your answer.

3. Discuss what is meant by ‘Cost of Capital’ and advise Underwood Limited on whether it is appropriate to use a hurdle rate when assessing the viability of a project considering the issues of using a hurdle rate.

4. Explain what is meant by the ‘internal rate of return’ and critically appraise its usefulness and limitations.

Answer 1

b) Based on the values calculated in the above I do not recommend the project to be continued because the project have negative NPV at the hurdle rate, hurdle rate is the least rate that should be achieved in order to for a project to continue. The ARR is also very low and the project is not even able to recover the initial capital completely if we ignore the salvage value.

c) The cost of capital is weighted average cost of capital from different source in which the fund has been raised and it shows what the company providers of capital requires to be compensated. The hurdle rate is rate which is the rate which is decided by the management for taking up the risk in the project besides the capital and if the hurdle rate is higher than the cost of capital then hurdle rate should be used.

d) Internal rate of return is the rate which the net present of the cash flow is zero. It is useful technique to see whether the IRR is greater than the opportunity cost of capital. The one issue with the IRR method is that it assumes that the reinvestment rate is also the IRR which is not always feasible.