Banden Ltd is a highly geared entity that wishes to expand its operations. Six possible cap- ital investments have been identified, but the entity only has access to a total of £620,000. The projects are not divisible and may not be postponed until a future period. After the projects end it is unlikely that similar investment opportunities will occur. Expected net cash inflows (including salvage value) Year 1 2 4 5 Initial outlay Project 70,000 64,000 63,000 62,000 60,000 82,000 A 70,000 75,000 48,000 62,000 40,000 35,000 70,000 87,000 70,000 70,000 246,000 180,000 B 48,000 62,000 50,000 82,000 C 73,000 62,000 70,000 175,000 180,000 180,000 150,000 D E 40,000 F Projects A and E are mutually exclusive. All projects are believed to be of similar risk to the company's existing capital investments. Any surplus funds may be invested in the money market to earn a return of 9 per cent per year. The money market may be assumed to be an efficient market. Banden's cost of capital is 12 per cent per year. Requirements (a) Calculate: @) the expected net present value; (ii) the expected profitability index associated with each of the six projects, and rank the projects according to both of these investment appraisal methods. Explain briefly why these rankings differ. (b) Give reasoned advice to Banden Ltd, recommending which projects should be selected. (c) A director of the entity has suggested that using the company's normal cost of capital might not be appropriate in a capital rationing situation. Explain whether you agree with the director.
Banden Ltd is a highly geared entity that wishes to expand its operations. Six possible cap- ital investments have been identified, but the entity only has access to a total of £620,000. The projects are not divisible and may not be postponed until a future period. After the projects end it is unlikely that similar investment opportunities will occur. Expected net cash inflows (including salvage value) Year 1 2 4 5 Initial outlay Project 70,000 64,000 63,000 62,000 60,000 82,000 A 70,000 75,000 48,000 62,000 40,000 35,000 70,000 87,000 70,000 70,000 246,000 180,000 B 48,000 62,000 50,000 82,000 C 73,000 62,000 70,000 175,000 180,000 180,000 150,000 D E 40,000 F Projects A and E are mutually exclusive. All projects are believed to be of similar risk to the company's existing capital investments. Any surplus funds may be invested in the money market to earn a return of 9 per cent per year. The money market may be assumed to be an efficient market. Banden's cost of capital is 12 per cent per year. Requirements (a) Calculate: @) the expected net present value; (ii) the expected profitability index associated with each of the six projects, and rank the projects according to both of these investment appraisal methods. Explain briefly why these rankings differ. (b) Give reasoned advice to Banden Ltd, recommending which projects should be selected. (c) A director of the entity has suggested that using the company's normal cost of capital might not be appropriate in a capital rationing situation. Explain whether you agree with the director.
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:Banden Ltd is a highly geared entity that wishes to expand its operations. Six possible cap-
ital investments have been identified, but the entity only has access to a total of £620,000.
The projects are not divisible and may not be postponed until a future period. After the
projects end it is unlikely that similar investment opportunities will occur.
Expected net cash inflows (including salvage value)
Year 1
4
5
Initial outlay
Project
£.
70,000
246,000
180,000
175,000
180,000
180,000
150,000
70,000
64,000
A
70,000
70,000
75,000
70,000
87,000
48,000
62,000
50,000
82,000
В
48,000
62,000
40,000
35,000
63,000
62,000
60,000
82,000
73,000
62,000
70,000
E
40,000
F
Projects A and E are mutually exclusive. All projects are believed to be of similar risk to
the company's existing capital investments.
Any surplus funds may be invested in the money market to earn a return of 9 per cent
per year. The money market may be assumed to be an efficient market.
Banden's cost of capital is 12 per cent per year.
Requirements
(a) Calculate:
) the expected net present value;
(ii) the expected profitability index associated with each of the six projects, and rank
the projects according to both of these investment appraisal methods. Explain
briefly why these rankings differ.
(b) Give reasoned advice to Banden Ltd, recommending which projects should be selected.
(c) A director of the entity has suggested that using the company's normal cost of capital
might not be appropriate in a capital rationing situation. Explain whether you agree with
the director.
(d) The director has also suggested the use of linear or integer programming to assist with
the selection of projects. Discuss the advantages and disadvantages of these mathe-
matical programming methods to Banden Ltd.
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