Quantitative factors - numerical questions (1)
Question 1
A company is faced with the choice between two projects X and Y. The cost information for the two projects is summarised below.
| X | Project | Y |
|---|---|---|
| 600 | Capital cost ($000) | 900 |
| Net cash inflow ($000) | ||
| 50 | Year 1 | 150 |
| 100 | Year 2 | 300 |
| 300 | Year 3 | 500 |
| 300 | Year 4 | 300 |
| 200 | Year 5 | 250 |
| 50 | Year 6 | 100 |
N.B. There are no residual values
(i) For each project determine the payback period and the average rate of return.
The firm has a screening tests of a maximum of 3.0 years for payback period and 12 % as the minimum rate for the average rate of return.
(ii) Explain the meaning of the term 'screening test'.
The firm has a company screening test of 10% for all projects after adjustment for the time value of money.
(iii) Explain the term 'time value of money.
(iv) Calculate the net present value for the best project found in i). Does this meet the firm's screening test?
Use the following discount factors (10% discount rate):
Year 1 0.909
Year 2 0.826
Year 3 0.751
Year 4 0.683
Year 5 0.621
Year 6 0.564
Question 2
Hertford Chemicals plc
Hertford Chemicals plc is considering investing in a new chemical processing plant, but has the choice of manufacturing one of two products on it. The firm requires a minimum return of 20% on any capital expenditure. Details of the two proposals are summarised below:
| Project A | Initial capital cost | Project B |
|---|---|---|
| $200,000 | $250,000 | |
| Net cash inflows | ||
| $50,000 | Year 1 | $20,000 |
| $100,000 | Year 2 | $150,000 |
| $200,000 | Year 3 | $250,000 |
| $200,000 | Year 4 | $100,000 |
| $100,000 | Year 5 | $150,000 |
(a) Calculate the payback period, average rate of return and the net present value for the two projects.
Use the following discount factors (20% discount rate):
Year 1 0.833
Year 2 0.694
Year 3 0.579
Year 4 0.482
Year 5 0.402
(b) On the basis of these measures only, which project would you recommend?
(c) What other factors, other than quantitative/financial factors, should you take into consideration when deciding between projects?
