Investment Appraisal

**Section A** SkyLogistics is evaluating the replacement cycle for its new fleet of electric delivery drones. Drone Model X costs $12,000. If replaced after 1 year, the running costs are $2,000 and resale value is $8,000. If replaced after 2 years, the running costs are $2,000 in year 1 and $3,500 in year 2, with a resale value of $5,000 at the end of year 2. The company's cost of capital is 10%. What is the Equivalent Annual Cost (EAC) of replacing the drones every 2 years? (Ignore tax and inflation).

**Section A** Oceanic Minerals is considering several deep-sea mining projects but faces strict capital rationing. The company has $10 million available. Project Alpha requires an initial investment of $4m and has an NPV of $1.2m. Project Beta requires an initial investment of $6m and has an NPV of $1.5m. Project Gamma requires an initial investment of $5m and has an NPV of $1.6m. Assuming the projects are divisible, what is the Profitability Index (PI) of Project Gamma?

**Section C** **NeuroMed PLC - Investment Appraisal** NeuroMed PLC is a biotechnology company evaluating the construction of a new manufacturing facility for a recently approved drug. The project requires an immediate initial investment of $5,000,000 in plant and machinery. The project has an expected life of 4 years, after which the plant and machinery will be sold for an estimated scrap value of $800,000 (in nominal terms). **Sales and Cost Projections (in current Year 0 terms):** - Year 1 Sales Volume: 100,000 units - Year 2 Sales Volume: 150,000 units - Year 3 Sales Volume: 150,000 units - Year 4 Sales Volume: 80,000 units - Selling price per unit: $40 - Variable cost per unit: $15 - Fixed operating costs: $500,000 per annum **Inflation Expectations:** - Selling price inflation: 4% per annum - Variable cost inflation: 5% per annum - Fixed operating costs inflation: 3% per annum **Taxation and Capital Allowances:** - NeuroMed pays corporate tax at a rate of 25%, payable in the same year the profit is generated. - Tax-allowable depreciation (capital allowances) is available on the plant and machinery at 25% per annum on a reducing balance basis. A balancing charge or allowance will arise in Year 4 upon disposal. **Cost of Capital:** - NeuroMed's nominal after-tax weighted average cost of capital (WACC) is 12%. **Required:** **(a)** Calculate the Net Present Value (NPV) of the proposed manufacturing facility. (14 marks) **(b)** Calculate the Internal Rate of Return (IRR) of the project. (You may use discount rates of 10% and 20% for your interpolation). (4 marks) **(c)** Briefly discuss how the incorporation of 'Real Options' might alter the investment decision for NeuroMed. (2 marks)

Section A TerraFirma Mining needs to replace its heavy excavation machinery. The machinery can be replaced every 2 years or every 3 years. The cost of capital is 10%. 2-year cycle: PV of costs = $145,000 3-year cycle: PV of costs = $205,000 Annuity factors at 10%: 2 years = 1.736, 3 years = 2.487 Based on the Equivalent Annual Cost (EAC), which replacement cycle should be chosen and what is its EAC?

Section A DeepEarth Extraction is evaluating a new mining project. The traditional Net Present Value (NPV) is slightly negative. However, the board notes that if mineral prices rise over the next two years, they can scale up operations significantly. If prices fall, they can sell the mining rights to a competitor. Which types of real options are present in this scenario?

Section C - Constructed Response AquaNet Co is a public utility company evaluating the construction of a new water desalination plant. The project will last for 4 years. Financial details: 1. Initial investment in plant and machinery is $50 million, payable immediately (Year 0). 2. The machinery will have a scrap value of $5 million at the end of Year 4. 3. Tax-allowable depreciation (capital allowances) is available at 25% per year on a reducing balance basis. A balancing charge or allowance will arise in Year 4. 4. Corporation tax is 30%, payable one year in arrears (i.e., Year 1 tax is paid in Year 2). 5. Expected sales volume is 10 million cubic meters of water per year. 6. Current selling price is $2.00 per cubic meter. This is expected to inflate by 4% per year. 7. Current variable costs are $0.80 per cubic meter. These are expected to inflate by 5% per year. 8. Fixed costs (excluding depreciation) are $3 million per year in current terms, inflating at 3% per year. 9. Working capital of $4 million is required immediately (Year 0) and will be fully recovered at the end of Year 4. 10. AquaNet's nominal after-tax cost of capital is 10%. Required: (a) Calculate the Net Present Value (NPV) of the desalination plant project. (14 marks) (b) Discuss the difference between sensitivity analysis and expected value (probability) analysis in assessing project risk, and recommend which is more appropriate for AquaNet Co. (6 marks)

'SteelForge Inc' is deciding between two heavy forging machines. Machine A has a life of 3 years and a Net Present Value (NPV) of costs of $120,000. Machine B has a life of 5 years and an NPV of costs of $180,000. The company's cost of capital is 10%. The 3-year annuity factor at 10% is 2.487. The 5-year annuity factor at 10% is 3.791. Based on the Equivalent Annual Cost (EAC), which machine should be chosen and why?

'AstroTour', a space tourism startup, is appraising a 10-year project. The company expects general inflation to be 4% per year. The real cost of capital is 8%. If AstroTour decides to discount the project's cash flows using the nominal (money) cost of capital, how must the cash flows be treated to ensure a correct Net Present Value (NPV) calculation?

CASE 4: SOLARIS GRID Solaris Grid is a public utility company evaluating a new 4-year solar infrastructure project. The project requires an initial investment of $8,000,000 in solar panels and equipment. The equipment will attract tax-allowable depreciation (capital allowances) at 25% per year on a reducing balance basis. The company expects to sell the equipment at the end of Year 4 for $1,500,000. The project will generate an additional 10,000 MWh of electricity per year. The current price of electricity is $400 per MWh, but this is expected to inflate by 5% per year. Operating costs are currently $1,200,000 per year and are expected to inflate by 3% per year. The project requires an initial working capital investment of $500,000 at Year 0, which will be fully recovered at the end of Year 4. Solaris Grid pays corporate tax at 20%, payable in the year the profit is generated. The company's nominal after-tax cost of capital is 10%. Required: (a) Calculate the Net Present Value (NPV) of the solar infrastructure project and recommend whether it should be accepted. (15 marks) (b) Discuss the concept of 'Real Options' in investment appraisal and identify two real options that Solaris Grid might possess regarding this project. (5 marks)

**Section A** MetroWater PLC, a public utility company, is evaluating a massive infrastructure project to build a new desalination plant. The project has a marginal negative Net Present Value (NPV). However, the board notes that building the plant gives them the exclusive right to expand into neighboring regions in five years if water demand surges. In the context of investment appraisal, what type of real option does this represent?

**Section A** LogisticsPlus is deciding whether to replace its delivery trucks every 2 years or every 3 years. The cost of capital is 10%. - A 2-year replacement cycle has a Present Value (PV) of total costs of $45,000. - A 3-year replacement cycle has a PV of total costs of $60,000. Annuity factors at 10%: 2 years = 1.736; 3 years = 2.487. Based on the Equivalent Annual Cost (EAC), which replacement cycle should be chosen and why?

**Section C** **EcoGrid Utilities PLC** EcoGrid Utilities PLC is a public utility company evaluating a major investment in a new smart-grid infrastructure project. The project will last for 4 years. **Financial Data:** - Initial investment in infrastructure: $12,000,000, payable immediately (Year 0). - The infrastructure will have a scrap value of $2,000,000 at the end of Year 4. - Tax-allowable depreciation (capital allowances) is available at 25% per year on a reducing balance basis. A balancing allowance or charge will arise in Year 4. - Initial working capital of $1,500,000 is required immediately. This will increase by inflation each year and will be fully recovered at the end of Year 4. - Expected annual revenue in current terms (Year 0 prices) is $8,000,000. - Expected annual operating costs in current terms (Year 0 prices) are $3,500,000. - General inflation is expected to be 4% per year. - Revenue is expected to inflate at 5% per year. - Operating costs are expected to inflate at 3% per year. - The corporate tax rate is 20%, payable in the year the profit is generated. - EcoGrid's nominal (money) weighted average cost of capital is 12%. **Required:** **(a)** Calculate the nominal (money) Net Present Value (NPV) of the smart-grid project and advise whether EcoGrid Utilities PLC should proceed with the investment. (14 marks) **(b)** Discuss the difference between nominal and real discount rates, and explain why the nominal approach was appropriate for this specific calculation. (6 marks)

**Section A** SolarGrid Municipal is evaluating a new solar farm project. At a discount rate of 10%, the project has a Net Present Value (NPV) of +$50,000. At a discount rate of 15%, the NPV is -$10,000. Using the interpolation method, what is the estimated Internal Rate of Return (IRR) of the project?

**Section A** OreCrush Mining is deciding on the replacement cycle for its heavy excavators. A new excavator costs $200,000. If replaced every 4 years, the present value of all costs (initial purchase, maintenance, and scrap value) discounted at the company's cost of capital of 8% is $250,000. The 4-year cumulative annuity factor at 8% is 3.312. What is the Equivalent Annual Cost (EAC) of replacing the excavator every 4 years?

**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)

Section A DeepSea Minerals PLC is evaluating two mutually exclusive underwater extraction machines with different useful lives. Machine X costs $400,000, has a 3-year life, and an NPV of costs of $520,000. Machine Y costs $550,000, has a 5-year life, and an NPV of costs of $710,000. The company's cost of capital is 10%. What is the Equivalent Annual Cost (EAC) of Machine Y? (Annuity factor for 10% at 5 years is 3.791)

Section A BioGenix is facing single-period capital rationing. It has $5m available to invest and is considering four divisible projects. Project A: Outlay $2m, NPV $0.6m Project B: Outlay $3m, NPV $1.2m Project C: Outlay $1.5m, NPV $0.5m Project D: Outlay $2.5m, NPV $0.8m In what order should the projects be ranked to maximize NPV?

Section C OrbitLogix PLC is a commercial space-tech company evaluating a project to deploy a new network of low-earth orbit satellites. The project requires an immediate capital investment of $120 million for satellite manufacturing and launch vehicles. The project is expected to generate the following real (current price) cash flows before tax: Year 1: $30 million Year 2: $45 million Year 3: $55 million Year 4: $40 million At the end of Year 4, the satellites will be decommissioned. The decommissioning cost is estimated at $15 million in real terms. Additional Information: 1. General inflation is expected to be 4% per year. All real cash flows (including decommissioning) will inflate at this general rate. 2. Tax-allowable depreciation (capital allowances) is available on the initial $120m investment at 25% per year on a reducing balance basis. A balancing allowance or charge will arise in Year 4 when the assets are scrapped for zero value. 3. Corporate tax is 20%, payable in the year the profit is generated. 4. The project requires an initial working capital investment of $10 million, which will increase by inflation each year. The total working capital will be fully recovered at the end of Year 4. 5. OrbitLogix has a nominal after-tax cost of capital of 12%. Required: (a) Calculate the nominal Net Present Value (NPV) of the satellite project and recommend whether it should be accepted. (15 marks) (b) Discuss the concept of 'Real Options' in investment appraisal and identify two real options that OrbitLogix might possess in relation to this project. (5 marks)