7 2 oO _ Q O: © ~ S oO E p n oO > SSIES este Level 10.3 Ss, . NS BEARNING INTENTIONS Chapter 35Le s McCain Foods is the world’ largest producer of frozen chips. The company focuses on continuous innovation t0 give competitive advantage and to allow the brand to deliver value and quality. At one of its major European foc ries, McCain has invested in a big wind powor project to generate electricity. This is used to cook and then freeze thousands of tonnes of chips each year, By reducing the cost of paying for energy, McCain's cash outflows are reduced. These cost savings meant that the wind power investment paid back its intial investment in just over 4 years. The rate of return is 8.6% per year. The discounted net present value (NPV), after 5 years, is $0.17 Although not very profitable, this investment fits in well with McCain's corporate social responsibilty strategy. Environmental groups claim that many more sustainable investment projects such as this are needed to reduce climate change, Discuss in a pair or a group: * Why might businesses focus more on the profitability of new investment than its environmental impact? 35.1 What is meant by investment appraisal? Investment means purchasing capital goods, such as equipment, vehicles and new buildings, with the expectation of earning future profits. All businesses make wvestment decisions. Many of these involve significant trategic issues, such as relocation of premises or the adoption of computer-assisted engineering methods, Investment appraisal means assessing the profitability of an investment decision. This is usually undertaken by using quantitative techniques. Managers use investment appraisal methods to assess whether the likely future returns on Projects will be greater than the costs and by how much, Non-financial issues can also be important and therefore qualitative appraisal of an investment project is often undertaken too, investment appraisal: evaluating the profitability or feasibility of an investment project. Chips: a sustainable investment in wind power The wind power has cut carbon dioxide emissions by 10000 > CAMBRIDGE INTERNATIONAL AS & A LEVEL BUSINESS: COURSEBOOK Figure 35.1: Investing in energy frorn vain used to cook and freeze McCain chips, profitable and a sustainable investment net present value (NPV): today’s value of estimated cash flows resulting from an invest ‘All business investments involve capital expenditure as 2 cash outflow, Investment projects are undertaken because the business expects there to be a return from them. in the form of cash inflows. These are received over the useful life of the assets purchased. Quantitative methods of appraisal make comparisons between the cash outflows or costs of the project and the expected future cash inflows Quantitative investment appraisal: what information is necessary? When appraising the profitability of investment projects using quantitative techniques, the following information will be required: * initial capital cost of the investment such as the cost of buildings and equipment estimated life expectancy or the “useful life’ of an asset residual value of the investment ~ at the end of their useful lives, the assets willbe Sold leading to a further cash inflow forecasted net cash flows from the project. These are the expected returns from the investment less its annual operating cost— 35 Investment appraisal A Level 10.3 Yer little of this financial data ¢ pr the qui ‘an be said 0 be ce Thosfors. the quantitative tet gues rely nag cert, wancial estimates and forecnsie OY Me Cash flow uncertainties casting cash flows 1 : sin For each of the follow onment an uncertain ‘explain one reason why there is likely to be some Uncertainty about future net cash flow f the techniques used to appraise t ct Forecast 10 Be anal Ras investment projects | project to construct » Fature eash and expensive lurury cars are referred to as forceasted net cash flog, fae fd wet cash fos, b investment in a new computerised barking system offering customers new services Using the latest equipment, which has 1 been thoroughly tested casted net cash flow: for ahly Se recast cash inflows less © new sports centre for which ‘on a small sample of the local population has bbeen done ssumed that the: d__ project to build @ new toll motorway bet + sash inflows are the same as the annual revenues woes armed from the project construction of an oil-fired power sta ssh outflows are the initial capital cost of the avestment and the annual operating costs, casting these cash flows is not easy and is rarely likely ces Sa ole eS be 100% accurate, With long-term investments, forecasts «to be made several years ahead. There will be the risk f external factors reducing the accuracy of the figures. example, when appraising the construction of a new identification tags. The scheme cost $100000 and rport, forecasts of cash flows many years ahead are likely 1500 items of equipment used for patier be required, The possible external factors affecting the tagged. According to the health service, «enue forecasts include The health service in Scotland has invested in 2 wi networking project in one of its Glasgow hospitals, It tracks medical equipment with radio frequency the hospital loses $60000 each year in wasted staff tme lookcn misplaced equipment such as defiorl + An economic recession could reduce both business ee and blon ates Oil price rises could lead to higher prices for air travel reducing demand levels + The construction of a new high-speed rail link might encourage some travellers to switch to this form of transport luture uncertainties cannot be removed from investment appraisal calculations. The possibility of uncertain and unpredicted events making cash flow forecasts inaccurate must, however, be constantly considered by managers, All investment decisions involve some risk due to this uncertainty. The question is: Will the future profits from the project compensate for these risks? Figure 35.2: Investment ina scheme toreduce the | cost of losing expensive hospital equipment s off quickly \ Discuss in a pair or a group: Under what circumstances should investments in healthcare projects be appraised using quantitative methods?>> CAMBRIDGE INTERNATIONAL AS & A 35.2 Quantitative techniques: payback and accounting rate of return ‘The basic quantitative methods of investment appraisal ate + payback period ‘+ accounting (or average) rate of return, payback period: length of time it takes for the net cash inflows to pay back the original capital cost of the investment. Payback method If a project costs $2 million and is expected to pay back $500000 per year, the payback period will be four years. This can then be compared with the payback on alternative investments. It is normal to refer to ‘year 0" as the time period in which the investment is made. The cash flow in ‘year 0 is therefore negative, shown by a bracketed amount (see Table 35.1), Table 35.1 shows the forecast annual net cash flows and ‘cumulative cash flows, This latter figure shows the running total of net cash flows. It becomes less and less negative as further cash inflows are received. Notice that in year 3 it becomes positive, so the initial capital cost has been paid back during this third year. But when during this year? If we assume that the cash flows are received evenly throughout the year (this may not be the case, of course), then payback will be at the end of the fourth month of the third year. How do we know this? At the end of year 2, $50000 is needed to pay back the remainder of the initial investment. A total of $150000 is expected during year 3; 550000 is one-third of $150000, and one-third of a year is the end of month 4. To find out this exact month, use this formula: Additional months to payback additional net cash inflow needed x 12 month ‘annual cash flow in year 3 vonts 550000 15 mon i S1S0000 eta LEVEL BUSINESS: COURSEBOOK “The payback period is therefore two years and four months ‘0 | (s00000) (500000) 1__ | 300000 (200000) 2__| 150000 (50000) 3 | 150000 100000 ‘4 | 100000 200000 {including residual value) Table 35.1: Forecast cash flows of an investment Why is the payback of a project important? ‘Managers can compare the payback period of a particular project with other alternative projects So as to put them in rank order. The payback period can be compared with a cut-off time period that the business may have laid down, For example, they may not accept any project proposal that pays back after five years, The decision for a cut-off time period may include the following reasons: © A business may have borrowed the finance for the investment and a long payback period will increase interest payments. ‘+ Evenif the finance was obtained internally, the capital has an opportunity cost of other purposes for which it could be used. The speedier the payback, the quicker the capital is made available for other projects. ‘+The longer the payback period, the more uncertain the whole investment becomes. The changes in the external environment that could occur to make a project unprofitable are likely to be much greater over ten years than over two. © Some managers are risk averse. They want to reduce risk to a minimum, so a quick payback reduces uncertainties for these managers. * Cash flows received in the future have less real value than cash flows today, owing to inflation. The more quickly money is returned, the higher is its real value. 586)Nigerian government selected me for water suppl Ned coreatisation IPP. involved ee ontracts to build and eerie frm es to regions of the coun profitability of these cane An analysis ofthe ne annual rate of return ; "te of retumn was forecast to be 28% ‘he Payback period was forecast to be 3.8 years Figure 35.3: Water supply — a profitable investment? EPRI — 2 Profitable investment? Discuss in a pair or a group: How accurate and reliable these forecasted quantitative resuits likely to be? Evaluation of the payback method The payback method is often used as a quick check on the ability of a project or as a means of comparing projects. ‘owever, itis rarely used in isolation from the other \westment appraisal methods (see Table 35.2). Itis quick and easy It does not measure to calculate. the overall profitability of a project. Indeed, it ignores all the cash flows after the payback period. Itmay be possible for an investment to give a very rapid return of capital, but then to offer no other cash inflows. The results are easily understood by managers. The emphasis on speed of return of cash flows gives the benefit of concentrating on the more accurate short- term forecasts of the projects profitability This concentration on the short term may lead businesses to reject very profitable investments just because they take some time to repay the capital. 35. Investment appraisal A Level 10.3 Theresultcanbe [+ Used to eliminate or identify projects that sive returns too far into the future timing ofthe cashflows dling the poyback period, This wil become Ereorer when the riciple of scouting Besamined inthe fina two appraeal methods (see Section 35.3). Itis particularly Useful for businesses. where liquidity is of ‘greater significance than overall profitability Table 35.2: Payback method: advantages and disadvantages Payback calculations 1. Caleulate the payback period on a project costing $3000 with forecasted net cash flows of $5000 ‘each year 2 Calculate the payback period on a project costing $4 milion with forecasted nat cash flows of $1.5, million each year. 3 Calculate the payback period on a project costing $250000 with forecasted nat cash flows of '$80000 each year. Accounting rate of return ‘The accounting rate of return (ARR) may also be referred to as the average rate of return. If it can be shown that Project Acreturns, on average, 8% per year while Project B returns 12% per year, then the decision between the alternative investments will be an easier one to make accounting rate of return (ARF veasures the annual profitability of an investment as a percentage of the average investment (average capital cost) ‘The ARR (°%) is measured by this formula: average annual profit average investment ARR x 100 where the average investment initial capital cost + residual capital value ay se7 >> CAMBRIDGE INTERNATIONAL AS & A LEVEL BUSINESS: COURSEBOOK Table 35.3 shows the expected net cash flows from a business investment in a fleet of new fuel-efficient vehicles. They cost $8 million. The inflows for years 1-3 are the annual cost savings made. In year 4, the expected residual value of the vehicles is included, ($8 million) 0 1 $3 millon 2 $3 million 3 $3 million 4 [3 million (including $2m residual capital value) Table 35. Net cash flows for fleet investment ‘The five stages in calculating ARR are shown in Table 35.4, 1. Add up all positive net | = $12 million cash flows, 2 Subtract the cost of investment. = $12 million - $8 million = $4 million (this is total profit __|or total net cash flow) 3 Divide by the lifespan. | = $4 million/4 = $1 million (this is the average annual profit) 4 Calculate the average | (68m + $2m) investment, _2 = $5m 5 Tocalculate the ARR | Sim %, divide the result in| 5m ~ 100 = 20% stage 3 by the average investment x 100. Table 35.4: The five stages in calculating ARR Why is the ARR of a project important? ‘What does this result mean? It indicates to the business that, on average over the lifespan of the investment, it can, expect an annual return of 20% on its investment. This could be compared with: * the ARR on other projects © the minimum expected return set by the business. This is called the criterion rate. (In the example above, if the business refused to accept any project with a return of less than 18%, the new vehicle fleet would satisfy this criterion.) ‘© the annual interest rate on loans If the ARR is less than the interest rate, it will not be worthwhile taking a loan to invest in the project. criterion rate: the minimum accounting rate of return that a business would accept before approving an investment Evaluation of average rate of return [ARR is a widely used measure for appraising projects, but itis best considered together with payback results. The two results then allow consideration of both profits and cash flow timings (see Table 35.5). It ignores the timing Of the cash flows. This could result in two projects having similar ‘ARR results, but one profitability, which is could pay back much the central objective more quickly than the of many business other. decisions It uses all of the cash flows, unlike the payback method, It focuses on As all cash inflows are included, the later cash flows, which are less likely to be accurate, are incorporated into the calculation, The result is easily understood and easy to compare with other projects that may be competing for the limited investment funds available, The time value of money is ignored as the cash flows have not been discounted The result can be quickly assessed against the predetermined criterion rate of the business. Table 35.5: Advantages and disadvantages of ARR 35.3 Quantitative techniques: discounted cash flow ‘You should by now understand that managers may be uncertain which project to invest in if the two basic methods of investment appraisal give conflicting results If Project A is estimated to pay back at the end of year 3 at an ARR of 15%, should this be preferred to project B with a payback of four years but an ARR of 17%?snagers need another investmem Manes problem of tren eet" APPraisal method that is P Fying to compare projects w nit ARR and payback swith praisal A Level 10.3 CONTINUED Periods. The third me crs both th ef net cashflows and the eof fear eee) ete et toe 0 [1$50000) (§80000) 1_|s25000 '$45000 ‘cash flow: 2 [s20000 $35000 a the present-day value ofa 3 [$2000 $1700 — 4 [$1500 310000 - 5 ]st0oa0 cluding] SSODD icc : residual capital value | residual capital valu Tects of inflation are ignored, a rational Person ive ie en) pital value Er esoon ow) rather accept a payment of §1000 today peteod of cnt of $1 000 in one year’s time. Ask yourself which uld choose, The payment today is preferred for three + \(can be spent immediately and the benefits of this penditure can be obtained immediately. There is no iting involved. hhe $1.000 could be saved at the current rate of crest, The total of cash plus interest will be preater van the offer of $1 000 in one year’s time. {he cash today is certain, but the future cash offer is \|ways open to uncertainty. his is taking the time value of money into consideration, discounting is the process of reducing the value of future ish flows to give them their value in today’s terms. How uch less is future cash worth compared to today’s money? ve answer depends on the rate of interest. If $1 000 wived today can be saved at 10%, then it will grow to | 100 in one year's time. Therefore, $1 100 in one year’s inne has the same value as $1 000 today given interest utes at 10%. This figure of $1 000 is called the present-day luc of $1100 received in one year’s time. Discounting, sleulates the present-day values of future cash flows so nat investment projects can be compared with each other by considering today’s value of their returns, Textile company plans investment | A textile business is planning an investment programme to overcome a problem of demand ‘exceeding capacity. Its considering two alternative | projects involving new machinery. The initial investments and future cash outflows are given in Table 35.6. In both cases, itis assumed that the machinery is sold for its residual capital value. Table 35.6 Calculate the payback for both projects 2 Explain which project should be selected if payback is the only criterion used, and why. 3° Calculate the ARR for both projects. usiness has a cut-off or criterion rate of * TBictora ne prec Would ether project be acceptable with this restriction? 5 Taking both the results of payback and ARR together, which project would you advise the business to invest in and why? What additional information would help you advise the business on the more suitable project? Discounting: how is it done? ‘The present-day value of a future sum of money depends (on two factors: * The higher the interest rate, the less value future cash has in today's money, ‘+ The longer into the future cash is received, the less value it has today. ‘These two variables, interest rates and time, are used to calculate discount factors. They are available in discount tables and an extract of one is given in Table 35.7, To use the discount factors to obtain present-day values of future cash flows, multiply the appropriate discount factor by the cash flow. For example, $3000 is expected in three years’ time. The current rate of interest is 10%. The discount factor to be. used is 0.75 (see 10%, Year 3 in Table 35.7). This means that $1 received in three years’ time is worth the same as 15 cents today. This discount factor is multiplied by $3000 and the present-day value is $2250. TS SRR 589 >> CAMBRIDGE INTERNATIONAL AS & A LEVEL BUSINES: ova Joss Jos: [oes [oss [oes spas Jose fous [ove fore [oss soar ove Jors Jar Joo Jose tors Jor foe Jose ass Joe 5 ]ors fous fos2 [or [ass Joao sort Joos [ose [ost [os ors tobi 357 tract from discounted cash flow table Net present value (NPV) This investment appraisal method uses discounted cash. flows. Its calculated by subtracting the capital cost of the investment from the total discounted cash flows, The three es in calculating NPV are: 1 Multiply net cash flows by discount factors. Cash flows. in year 0 are never discounted, as they are present-day values already, 2 Add the discounted net cash flows. 3 Subtract the capital cost to give the NPV, ‘The working is clearly displayed in Table 35.8. The initial cost of the investment is a current cost paid out in year 0. Current cash flows are not discounted NPV is now calculated: OURSEBOOK What does this result mean? The project earns $1949 in today's money values, So if the finance needed can be borrowed at an interest rate of less than 8%, the investment will be profitable. What would happen to the NPV if the discount rate was raised? If interest rates increased, the business would be advised to discount future cash flows at a higher rate. This will reduce the NPV, as future cash flows are worth even less when they are discounted at a higher rate. The choice of discount rate is crucial to the assessment of projects using this methou of appraisal. Usually, businesses will choose a rate of discount that reflects the interest cost of borrowing the capital to finance the investment. Even if finance is raised internally, the rate of interest should be used to discount future returns. This is because of the opportunity cost of internal finance as it could be used to gain interest if left oon deposit in a bank. An alternative approach to selecting the discount rate is for a business to adopt a cut-off or criterion rate. The business would use this to discount the returns on a project and, if the NPV is positive, the investment could go ahead, Figure 35.4 shows how NPV declines as the rate of discount used increases, 10000 5000 total discounted cash flows = $11940 original investment (s10000) S net present value = 51940 z ° 5000 0 | (s10000) 1 ($1000) 1 $5000 0.93 $4650 10000 2 $4000) 0.86 $3440 3 $3000 7s) $2370 Figure 35.4: NPV as a function of discount rate 4 $2000) O74 $1480 Table 35. 590 > When calculating investment appraisal methods, you ate advised to lay out your working carefully, using the forms of table used in this chapter.35 Investment appraisal A Level 10.3 aS A in ili cad ation of the NPV considers both the nning of cash flows vd the size of them in ving at an appraisal It's reasonably complex to calculate and to explain, especially to non numerate managers, + “be rate of discount 1 be varied to allow + different economic | umstances. For The final resut depends ‘onthe rate of ciscount Used and expectations ut interest rates may be wrong, 4 stance, the rate of scount could be creased if there was | general expectation NPVs can be compared atinterest rates were | with other projects, | bout to rise but only ifthe initial capital costs the + considers the te | peat the | salue of money and the method does not | cokes the opportunity Provide a percentage Fate of return on the investment. cost of money into ‘unt. Table 38.9: Advantages and disadvantages of NPV Discounting cash flows Calculate the present-day values of the following cash flows: 2 $1000 expected in four years’ time at a prevailing rate of interest of 10% b $2000 expected in six years’ time at 2 prevailing rate of interest of 16% € $6000 expected in one year’s time at @ prevailing rate of interest of 20%. The following net cash flows have been forecast | by a manufacturer for the purchase of @ labour saving machine ° (15000), 1 8000 2 10000 |B 5000 4 5000 Table 35.10 @ Calculate the simple payback period, b Discount all cash flows at a discount rate of 10%. © Calculate the NPV. Net present value Table 35.11 shows discounted cash flows (OCFs) at varying rates of interest. Using the data: ‘a Recalculate the NPV at a discount rate of 20%, b Explain why the NPV is negative. ¢ Explain why the project would not be viable if the business had to borrow finance at 20%, Ifthe criterion rate used by the business for new investments is 10%, would this project have @ positive NPY, and would it therefore be acceptable? (0 | 135000) [($35000) | ($3500) | (s35000) 1 _| sisooo | $13950 | 13350 | $12705 2 | s15000 | si2900 [$i1850 | s10770 3_| s1oo00 [$7900 [$7100 | 6090 ‘4 | s10000 [$7400 [$6400 | $5160 NPV 7150 [$3700 | ($275) Table 35.11 35.4 Investment appraisal decisions Major investment projects will always be appraised in quantitative and financial terms but there are other factors ‘hich will influence these important decisions too. Quantitative results and their impact on investment decisions Sections 35.2 and 35.3 examined the three main quantitative appraisal methods. They focus on the speed with which ‘the capital investment is returned and the profit on an_-—— > CAMBRIDGE INTERNATIONAL AS & A LEVEL BUSINESS: COURSEBOOK investment, Most businesses will establish investment criteria for these three techniques which future projects must satis before approval for a project is given. Bor example: + Payback within three years © Accounting rate of return of at least 15 # Net present value of at least 18% of the original capital invested yen when these criteria are satisfied, « project might be rejected by senior managers if there are non-quantitative called asons for not proceeding with it, Thes Qualitative factors and their impact on investment decisions Investment appraisal techniques provide numerical data, which are important in taking decisions. However, no manager can afford to ignore the other factors that cannot be easily expressed in a numerical form but have a crucial impact on a decision. These qualitative factors include: * Impact on the environment and the local community. Environmental pressure groups may force businesses to consider carefully plans for developments in sensitive areas. Bad publicity stemming from a proposed investment plan may dissuade managers from going ahead with a project because of the long-run impact on brand image and sales. Corporate social responsibility objectives may take priority over profit targets. * Refusal of planning permission. This would prevent continuation of the scheme. It is the duty of local Planning officers to weigh up the costs and benefits of a planned undertaking and to act in the best interests of the community. The plans for an investment project might have to be heavily revised before they are acceptable to local planning authorities. + Aims and objectives of the business. For example, the decision to close bank branches and replace them with internet- and telephone-banking services involves considerable capital expenditure, as well as the potential for long-term savings. Managers may, however, be reluctant to pursue these investment policies if the objective of giving excellent and personal customer service could be threatened. ‘+ Impact on the workforce. A decision to replace large numbers of employees with automated machinery may be reversed if employer-employee relations could be badly damaged, ‘+ Acceptability of risk. Different managers are prepared to accept different degrees of risk. No amount of ——————_—__—_—_—. p will convince some managers, previous experience, to accept » ect that involves a considerable chance of failure Unless the question asks only for an analysis of quantitative (numerical) factors, your answers to investment appraisal questions should include an assessment of qualitative factors too New investments in Indian hotel developments take up to 10 years to pay back the intial capital but the annus! rate of retum can be high, at around 12% in the long term. In contrast, new apartment developments can pay back within one year. Some buyers even pay 2 cash deposit before a brick has been laid, aiding cash Sows of the development. Hotels are often in areas of igh land value and this value can rise greatly over ime Figure 35.5: A new Delhi apartment block investment which might pay back faster than a hotel investment Discuss in a pair or a group: Would you advise Incian development companies to only focus on building new apartments and not hotels? Justify your answertin Period to payee the ial eaptareort ‘annual profit asa percentage |* present-day value ofall net cash of the average capital cost flows when finance is limited * when interest rates me ee are high ‘comparing with the criterion |» to assess whether the project ‘comparing with the return from other projects comparing with the cost of makes a return when cash flows are discounted + for comparing other projects with a| similar capital cost finance (rate of interest) does not calculate the profit from an does not give a present. a CAMBRIDGE INTERNATIONAL AS & A LEVEL BUSINESS: COURSEBOOK In preparing your answer to Q7 in Activity 35.6, how did you decide on the recommended location? Did you thi auantitative results were more important than qualitative factors? ink that Explain to another learner how you made your decision about which location to recommend. Did your partner reach different conclusions? How would you defend your awn conclusion? Or can you now criticise your own conclusion? Decision. 7 1g questions 7 1 King and Green Ltd Xing and Green Ltd isa soft drinks business. It manufactures and sells a wide range of soft drinks Since the huge srowth of supermarket own-label brands, the business has depended for most of is sales on cats and restaurants ‘mainly inthe south of the country. The company is profitable, but ony just, andthe return on capital employed below those of much larger drinks businesses, The directors of King and Green are considering investing in sew equipment to update the production line. There ate two main options: Option 1: purchase fully automated equipment that would require just one operator per shift, This would allow a very fast switch from one type of soft drink to another. Water-pollution levels are expected to be very low. Two shifts a day will be used. 2 ‘Option 2: invest in less expensive machines that have an GS ‘but higher pollution levels, Each machine needs its own operator for each shift. Four: ‘would be needed, each producing one type of soft drink. The firm operates two shifts a day at present, so four production workers are needed for each shift. ‘The expected life of each option is five years. Including labour costs, the net cash flows (cash returns less running costs) anticipated from each option are shown in Table 35.14, The total inital investment required would be: * Option 1 355000 : + Option 2 $240000. | ‘The company can borrow capital at 10%, Machinery will be sold for its expected residual value atthe end of year 5. 1/150 120, 2110 72 ! 3} 90 72 ' 4 70 a2 i 5 70 (including residual capital value of 20) 62 (including residual capital value of 10) Table 35.14: Net cash flowsrenner Level 10.3 Using cast , ie cash flow data, undertake a payback period ‘an investment appraisal of the two options using: a b accounting rate of return (a © net present value, al 2 Using the results of your wine Son of 0m nesta appraisal and other information, evaluate which prost tay ‘st in. Justify your advice. Asia Print (AP) ~ investing to stay competitive Pisa large printing busines ornare paces na NETY Competitive market ass elaively easy for ne frst ein using the atest lees o maintain market share, the directors of AP are considering two alternative new Project ¥: A newly designed, hi olour capab wo highly ighly automated Japanese-built print facilities and full- 1 Direct inte spanese-built printing press with fast changeover facilities an Trice eet iterne inks with customers would allow for rapid input of new material to be printed [ie RE) Nezineg operatives wll be required an this would mean sx redundancies fom existing employees roject Z: A semi-automated Ge eet ‘utomated German-built machine with a more limited range of facilities but with proven cliability. Existing employees could operat ‘ie seca coun sega cae eae as eld bo redundancies. Itis very noisy {he finance director is appraising the investment in these two machines. He gathered the following data Each tional unit produced would be sold for an average of $1.25 but there would be additional variable costs of S0.5 per unit. In addition, the annual operational cost of the two machines is expected to be $1 million for Y and $0.5 mnillion for Z, The introduction of either machine would involve considerable disruption to existing production. Employees would have to be selected and trained for Project Y and the trade union is very worried about potential job cuts. The residual capital value of Y is expected to be $1 million and of Z, $0.5 million. Further information is given in Table 35.15. Purchase price ($m) 20 2 Expected life expectancy Syears a years, Forecast annual sales (millions of units) [8 é Table 35.15: Data needed for investment appraisal 1 Calculate the forecast annual net cash flows from the information given. 8] 2 Calculate the payback period for both projects. (4) 3 Calculate the ARR for both projects. ta 4 Calculate the net present-day value for both projects. The company's existing cost of borrowed capital is 12%. a 5 Using your results forall three methods of investment appraisal and othe information, evaluate which project AP should invest in. Justify your advice. Rr