Section C

Titanium Forge PLC

Titanium Forge PLC, a heavy manufacturing company, is evaluating the replacement of its traditional coal-fired blast furnace with a new, state-of-the-art green-energy electric arc furnace. The company's cost of capital is 10%.

The following information is available:

1. The new furnace will cost $5,000,000, payable immediately (Year 0).
2. It will have a useful life of 4 years, after which it will be sold for an estimated scrap value of $500,000 (in Year 4 prices).
3. The new furnace will generate annual savings in energy and materials of $1,800,000 in current terms (Year 0 prices). These savings are expected to inflate at 5% per annum.
4. Additional maintenance costs will be $200,000 per year in current terms, inflating at 3% per annum.
5. The project requires an initial investment in working capital of $300,000 at Year 0. This will need to increase by $50,000 at the start of Year 1 and $50,000 at the start of Year 2. All working capital will be fully recovered at the end of the project (Year 4).
6. Titanium Forge pays corporate tax at 25%, payable in the year the cash flow occurs.
7. The company can claim tax-allowable depreciation (capital allowances) on the initial cost of the furnace at 20% per annum on a reducing balance basis. A balancing allowance or charge will arise in Year 4 when the asset is sold.

Required:

(a) Calculate the nominal (money) Net Present Value (NPV) of the new electric arc furnace project. Show all workings clearly. (15 marks)

(b) Discuss the advantages and disadvantages of using the Internal Rate of Return (IRR) method compared to NPV when appraising mutually exclusive projects. (5 marks)

**Part (a) NPV Calculation** *1. Inflated Cash Flows ($'000)* Year 1: Savings = 1,800 * 1.05 = 1,890. Maint = 200 * 1.03 = 206. Net = 1,684. Year 2: Savings = 1,890 * 1.05 = 1,984.5. Maint = 206 * 1.03 = 212.2. Net = 1,772.3. Year 3: Savings = 1,984.5 * 1.05 = 2,083.7. Maint = 212.2 * 1.03 = 218.5. Net = 1,865.2. Year 4: Savings = 2,083.7 * 1.05 = 2,187.9. Maint = 218.5 * 1.03 = 225.1. Net = 1,962.8. *2. Tax on Operating Cash Flows (25%)* Y1: 1,684 * 25% = (421.0) Y2: 1,772.3 * 25% = (443.1) Y3: 1,865.2 * 25% = (466.3) Y4: 1,962.8 * 25% = (490.7) *3. Capital Allowances (Tax Shield at 25%)* Cost = 5,000 Y1: CA = 5,000 * 20% = 1,000. Tax shield = 250. WDV = 4,000. Y2: CA = 4,000 * 20% = 800. Tax shield = 200. WDV = 3,200. Y3: CA = 3,200 * 20% = 640. Tax shield = 160. WDV = 2,560. Y4: Scrap = 500. Balancing Allowance = 2,560 - 500 = 2,060. Tax shield = 515. *4. Working Capital* Y0: (300) Y1: (50) Y2: (50) Y3: 0 Y4: Recovery = 300 + 50 + 50 = 400 *5. Net Cash Flows and Discounting (10%)* Y0: (5,000) - 300 = (5,300) * 1.000 = (5,300) Y1: 1,684 - 421 + 250 - 50 = 1,463 * 0.909 = 1,329.9 Y2: 1,772.3 - 443.1 + 200 - 50 = 1,479.2 * 0.826 = 1,221.8 Y3: 1,865.2 - 466.3 + 160 = 1,558.9 * 0.751 = 1,170.7 Y4: 1,962.8 - 490.7 + 515 + 500 (scrap) + 400 (WC) = 2,887.1 * 0.683 = 1,971.9 NPV = (5,300) + 1,329.9 + 1,221.8 + 1,170.7 + 1,971.9 = +$394.3k (or $394,300). **Part (b) NPV vs IRR** - **Absolute vs Relative:** NPV measures the absolute increase in shareholder wealth in dollar terms, which aligns with the primary objective of financial management. IRR is a relative percentage measure and ignores the scale of the investment. A small project might have a high IRR but add little actual value. - **Mutually Exclusive Projects:** When choosing between mutually exclusive projects, IRR can lead to the wrong decision if the projects are of different sizes or have different cash flow timings. NPV will always point to the project that maximizes wealth. - **Reinvestment Assumption:** NPV assumes cash flows are reinvested at the cost of capital, which is realistic. IRR assumes cash flows are reinvested at the IRR itself, which is often overly optimistic. - **Non-conventional Cash Flows:** If a project has non-conventional cash flows (e.g., negative cash flows in later years), it can result in multiple IRRs, making the metric useless. NPV does not suffer from this issue.