Capaldi plc has the following investment opportunities, none of which is divisible, i.e. each project must be

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Question:

Capaldi plc has the following investment opportunities, none of which is divisible, i.e. each project must be undertaken in its entirety, or not at all, it isn’t possible to carry out a fraction of a project:

Project	Profitability Index	Initial Investment £000
A	1.42	700
B	1.75	1,000
C	1.75	800
D	1.50	1,600
E	1.90	900

Funding a portfolio of these projects would not require a change to the company’s financial structure and each project has the same risk as the company’s existing business. Each project has a conventional cash flow profile with a single initial investment outlay. Projects B and C are mutually exclusive. The company has investment funds that are limited to a total of £4m. Any surplus funds can be used to reduce the company’s bank overdraft, on which interest is currently payable at 6% p.a.

The Chief Financial Officer (CFO) intends to use the historical weighted average cost of capital of 8% to appraise these potential investments: however, the newly appointed CEO of the company argues that the relevant discount rate is the internal rate of return on the best project rejected because of the budget constraint.

Required:

a) Define the Internal Rate of Return (IRR) concept and explain how it may be used in project appraisal;

b) Explain what is meant by “a conventional cash flow profile” and explain its significance in relation to IRR;

c) Using a discount rate of 8%, identify the projects that should be selected to maximise net present value (NPV) and calculate the NPV figure that results from your selected portfolio of projects;

d) Again using a discount rate of 8%, identify the projects that should be selected to maximise NPV and calculate the NPV figure that results from your selected portfolio of projects if the projects were divisible, i.e. fractions of a project could be undertaken;

e) Comment on the relative merits of the claims of the CEO and CFO regarding the most appropriate discount rate