Fivestar pic is considering two mutually exclusive projects. Project X requires an immediate cash outflow of...

 

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Fivestar pic is considering two mutually exclusive projects. Project X requires an immediate cash outflow of £2.5m and Project Y requires £2m. Both projects will have a potential productive life of three years. The projected accountant's figures for the first year of each of the projects would be: Project X (E) 2,100,000 (300,000) (800,000) Sales Labour Materials Direct overhead Allocated overhead (100,000) (80,000) (50,000) Profit 770,000 For the second and third year of both projects, the accounts department also estimates the specific annual inflation rates for sales and costs: Sales Depreciation Labour Materials Direct overhead Allocated overhead 5% 10% 4% 7% 5% Depreciation Other relevant information: An additional investment of £35,000 in working capital will be needed for Project X, and an additional investment of £30,000 in working capital will be needed for Project Y. Both of them are recoverable at the end of the projects. Allocated overhead consist of central administrative costs which are incurred with or without the projects. The money cost of capital is 16% per annum. Taxation is ignored. nil Required: Use the money cash flows and money cost of capital to calculate the NPV of the two projects and recommend the most appropriate course of action. (10 marks) Now assume that the general inflation rate is anticipated to be 5% per annum. Calculate the real cash flows and the real cost of capital and use these to calculate the NPVs. (6 marks) Discuss the appropriateness in applying the money rate or real rate as a discount rate in a project appraisal practice. (4 marks) Fivestar pic is considering two mutually exclusive projects. Project X requires an immediate cash outflow of £2.5m and Project Y requires £2m. Both projects will have a potential productive life of three years. The projected accountant's figures for the first year of each of the projects would be: Project X (E) 2,100,000 (300,000) (800,000) Sales Labour Materials Direct overhead Allocated overhead (100,000) (80,000) (50,000) Profit 770,000 For the second and third year of both projects, the accounts department also estimates the specific annual inflation rates for sales and costs: Sales Depreciation Labour Materials Direct overhead Allocated overhead 5% 10% 4% 7% 5% Depreciation Other relevant information: An additional investment of £35,000 in working capital will be needed for Project X, and an additional investment of £30,000 in working capital will be needed for Project Y. Both of them are recoverable at the end of the projects. Allocated overhead consist of central administrative costs which are incurred with or without the projects. The money cost of capital is 16% per annum. Taxation is ignored. nil Required: Use the money cash flows and money cost of capital to calculate the NPV of the two projects and recommend the most appropriate course of action. (10 marks) Now assume that the general inflation rate is anticipated to be 5% per annum. Calculate the real cash flows and the real cost of capital and use these to calculate the NPVs. (6 marks) Discuss the appropriateness in applying the money rate or real rate as a discount rate in a project appraisal practice. (4 marks)

Answer rating: 100% (QA)

a To calculate the NP V of the two projects we need to first calculate the cash flows for each project For Project X the cash flows are Year 1 Cash In flow 2 100 000 Cash Out flow 2 500 000 35 000 2 5... View the full answer