Compare and contrast the net present value and internal rate of return techniques.

Ltd is assessing an investment project: the company plans to manufacture a new

product, ‘product Y’. The project is based on market research undertaken at a cost of

£200,000.

An initial investment of £30m is required: all of this will be invested in new machinery. The

company’s depreciation policy is to depreciate machinery over five years using the

straight-line method. The project will also require an investment in working capital of £5m

at the start (i.e. in year 0), which is expected to be recovered when production using the

new machinery stops at the end of year 6.

Production of product Y will take place in an empty building that is already owned by Vigo

Ltd. If the investment project does not proceed, the building will be rented out for £1.5m

per annum.

Forecast revenues from the sale of product X are £15m in year 1 and are expected to rise

by 2% per annum until the end of year 6. Costs are estimated to be 40% of revenues.

However, it is estimated that the production of product Y will cause sales of another of

Vigo Ltd’s products, product X, to decrease by 20%. In year 1, product X has estimated

revenues in year 1, of £7m. Revenues from product X are forecast to grow at 1% per

annum.

For management accounting and costing purposes, head office costs are allocated to

departments on product lines on the basis of 10% of revenues generated.

Tax is chargeable at 19% on taxable profits made and is paid one year in arrears. Capital

allowances of £7.5m per annum can be claimed in each of years 3 to 6 inclusive,

respectively. Capital allowances can be subtracted from revenues as part of the

calculation of taxable profits.

Vigo Ltd’s cost of capital is 4%.

Required:

(a) Calculate the net present value of the investment project.

(26 marks)

(b) Calculate the payback period of the investment project.

(4 marks)

(c) Prepare a data table that shows the impact on net present value of varying

percentages of lost revenues from product X. You should include a range of

lost revenues from 15% to 25% and show the effect of a range of revenue

growth from 1.5% to 2.5%.

(4 marks)

(d) Compare and contrast the net present value and internal rate of return

techniques.

(16 marks)

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