Director Case
Autor: vicky keung • March 16, 2015 • Article Review • 539 Words (3 Pages) • 884 Views
Q.1
(a) Director A used average profit as a measurement of investment decision but it is not suitable. This is because it has not taken time value of money or incremental of cash flow in account. Therefore, the investment decision should be based on cash flow rather than average profile.
Director B used discounted payback period as a measurement of investment decision. Firstly, payback period is to the length of time required to recover the cost of an investment, but it ignore the time value of money and the further cash flow would considered as time ‘zero’ after the cost has been recovered. However, discounted payback period has taken account into time value of money, but it still ignore the further cash flow after breakeven from undertaking the initial expenditure. Project that have discounted period must have positive or zero net present value (NPV). In this case which is two mutually exclusive investments might result a shorter discounted payback period but not maximized NPV.
Director C used profit made for investment decision. From director C, he argued that company could make £35,000 per year, which is made from money market investment that interest 10% per year. However, if the cost of capital is larger than 10% yield of money market deposit, NPV would be negative. Therefore, the decision should be based on whether the projects have zero or positive NPV.
(b)
Investment 1 £000
Year 0 1 2 3 4 5 6
Initial cost (500)
Revenue (9%increase) 400 491 594 712 847
Production costs (9%increase) 260 327 416 583 706
140 164 178 129 141
Tax (25%) (35) (41) (45) (32) (35)
Tax saving 31 24 18 13 10
Balancing allowance saving 30
Net cash flows (500) 140 160 161 102 122 5
Discounted factors 1 0.865 0.749 0.648 0.561 0.485 0.420
Present value (500) 121 120 104 57 59 2
NPV=(-500+121+120+104+57+59+2)*1000
=-£37,000
No discounted payback period
Investment 2 £000
Year 0 1 2 3 4 5 6
Initial cost (175)
Revenue (9%increase) 500 654 760 829 988
Production costs (9%increase) 460 567 653 764 889
40 87 107 65 99
Tax
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