Chapter 5 • Practical aspects of investment appraisal
Year Project A Project B Project C
£m £m £m
0 (1.6) (2.3) –
1 (0.8) 0.6 (2.5)
2 0.7 0.9 0.8
3 1.5 0.9 1.5
4 1.5 0.5 1.4
5 0.4 – 0.5All of these projects are typical of projects that the business has undertaken in the
past. The business’s cost of capital is 15 per cent p.a.
The entire cash flows of Project A for years 0 and 1, of Project B for year 0, and of
Project C for year 1 are capital expenditure. The subsequent net cash inflows are net
operating cash surpluses.
The business is not able to raise more than £2 million of investment finance in each of
years 0 and 1. However, to the extent that the business does not invest its full £2 million
in year 0, it will be allowed to use it in year 1. The business can also use any operating
cash surpluses from previously undertaken investments as new investment finance.
In past years the business has used all of its investment finance. It is expected that
past investments will produce operating cash surpluses as follows:Year £m
1 0.5
2 0.5
3 0.3
4 0.2
5 0.1
6 and thereafter 0.0Set out the various statements (equations and/or inequalities) that can be subjected to
linear programming to provide the management of the business with guidance on the
best investment strategy for years 0 and 1. (The solution to the linear programming
problem is notrequired.)
Work to the nearest £100,000. Assume that all cash flows occur on 31 December of the
relevant year. Ignore inflation and taxation.5.7 Prentice Products Ltd’s products development department has just developed a new
product, a cordless hair dryer for use in hairdressing salons. Were production to go
ahead it would start on 1 January 20X1.
Manufacturing the hair dryer would require the purchase of some new plant costing
£500,000, payable on 31 December 20X0. At the end of 20X4, this plant would be
scrapped (zero disposal proceeds). The business’s policy is to depreciate plant in equal
instalments over its estimated lifetime. For tax purposes, the equipment would attract
annual capital allowances of 25 per cent, reducing balance. The funds for purchasing
this plant would come from a bank loan, which would be raised on 31 December 20X0
and repaid on 31 December 20X4. Interest on the loan would be at a fixed rate of 10 per
cent p.a. (gross), payable at the end of each year. The business’s after-tax weighted
average cost of capital is expected to be 15 per cent for the foreseeable future.
Prentice Products Ltd would not undertake manufacturing and selling the hair dryers
unless the project could generate an increase in the present wealth of the shareholders
of at least £200,000.