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New Plc is considering whether to replace existing machineries. This will require an initial investment of £1.2million. New machineries would have an expected life of six years. At the end of six years, they could be sold for £150,000. Replacement of machineries is expected to generate additional annual revenues of £400,000. The incremental costs are estimated to be 20% of the additional revenues for the first year and 15% of additional annual revenues for the rest of the project.

New Plc is also considering a request form a large client to manufacture a new product. This will require a new investment of £800,000 in technology. The project will last for six years and is expected to generate annual net cash flows of £200,000. It will not have any residual value at the end of its life.

New Plc employs a discount rate of 12% and does not pay any corporation tax. Management team has decided to invest a limited capital of £1.5million in new projects. The two projects under consideration are independent and indivisible.

You are required to:

  1. EstimatetheNetPresentValue(NPV),InternalRateofReturn(IRR)andPayback

    Period (PP) techniques and recommend which project(s) the company should undertake. State any assumptions made, when applying these techniques. Show all the calculations.

    (45 marks)

    (150-200 words)

  2. Suggest whether the recommended project(s) is more sensitive to initial investment or discount rate. Support your answer with the relevant estimations.

    (15 marks)

    (50 -100 words)

  3. Explain how your recommendation would have changed if both projects were divisible.

    (10 marks)

    (50 -100 words)

  4. Assume that company’s discount rate of 12% is given in real terms, but new projects’ cash flows are estimated in nominal terms. Assume that the annual inflation rate is expected to be 3%. Suggest whether your recommendation in part (a) will change.

    (10 marks)

    (up to 50 words)

5

e. NewPlc.isconsideringarights’issuetoraisefundsfornewinvestments.Discuss the benefits and limitations of a rights’ issue.

(20 marks)

(150-200 words)

Total 100 marks

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