Problems
4.6 Cool Ltd’s main financial objective is to maximise the wealth of its shareholders. Cool
specialises in providing a service for its clients. All of the work that it undertakes is of
a similar type for similar clients.
Cool’s management is contemplating offering a new service. This will require the
acquisition of an item of plant on 1 June 20X4.
Cool intends to buy the plant for £300,000, payable on the date of acquisition. It is
estimated that the asset will have a negligible market value by 31 May 20X8 and will be
scrapped on that date.
A study of likely sales demand for the new service suggests that it will be as follows:
Year ending 31 May £000
20X5 220
20X6 250
20X7 300
20X8 260Variable operating costs associated with the new service are estimated at 30 per cent
of the sales revenue figure.
The introduction of the new service is planned to coincide with the discontinuance
of an existing activity. This discontinuance will release labour. If the new service is intro-
duced, the staff currently employed on the existing activity can all be fully employed
throughout the four years at a total salary bill of £45,000 p.a.
If the new service is not introduced, it is estimated that the existing activity could be
kept going until 31 May 20X7, generating revenues as follows:Year ending 31 May £000
20X5 100
20X6 80
20X7 80Variable operating costs associated with the existing service are also estimated at
30 per cent of the sales revenue figure.
If the new service is not introduced, it is envisaged that the staff will be made redund-
ant and paid total redundancy pay of £20,000 on 31 May 20X7. This item was taken
into account in the analysis on which the original decision to start the existing service
was based, several years ago. If the new service is introduced, staff will be made redund-
ant upon its conclusion on 31 May 20X8, and paid total redundancy pay of £22,000 at
that time.
Labour is a fixed cost (that is, it does not vary with the level of output). Exactly the
same staff will be employed in the provision of either service.
Apart from those that have already been mentioned, there are estimated to be no
incremental operating costs involved with offering these services.
The cost of finance to support the project is expected to be 10 per cent p.a.
(a) Prepare a schedule that derives the annual net relevant cash flows associated with
the decision as to whether Cool should acquire the plant and offer the new service,
based on the information provided above, and use it to draw a conclusion about this
decision on the basis of the project’s net present value as at 31 May 20X4.
(b) Estimate the internal rate of return for the project.
(c) Discuss the factors that Cool needs to take into account in respect of the decision,
other than the NPV and IRR.