Capital Budgeting: FourOpens Limited Essay

You are a manager at FourOpens Limited, a tennis racket manufacturer based in the UK.

Part A
The company has £1.2m to invest in new machinery for drilling tennis rackets. It is considering two machines but only has sufficient cash to accept one of them as each machine costs £1.2m. The projected cash flows of the two potential investments are shown below. The directors have asked for your help and advice in reaching a decision on which investment project to accept. The discount rate is 9%.

Andy Milos
Cash flows £000 £000
Cash inflows year 1 375 225
Cash inflows year 2 450 375
Cash inflows year 3 300 450
Cash inflows year 4 300 360
Cash inflows year 5 225 300

Cash inflow from sale of the investment at the end of year 5 150 225

Required

For both investment projects calculate:
1) Payback Period (PP);
2) Accounting Rate of Return (ARR) using the average investment method;
3) Net Present Value (NPV);
4) Internal Rate of Return (IRR) using interpolation.

Clearly show your workings.

Total marks 30

Part B
You were provided also with the details about an alternative machine (Serena) that would require an initial investment of £840,000. You find below the projections about the investment in machine Serena.

2

Serena
Cash flows £000
Cash inflows year 1       400
Cash inflows year 2       370
Cash inflows year 3       50
Cash inflows year 4       20
Cash inflow from the sale of the investment at the end of year 4 0. You also got new projections which show that machine Milos is now expected to generate cash inflows that are 10% lower than the original ones and the cash flow at the end of the investment is now nil.

Required:

For the machine Serena and the revised machine Milos, calculate:
1) Payback Period (PP);
2) Accounting Rate of Return (ARR) using the average investment method;
3) Net Present Value (NPV);
4) Internal Rate of Return (IRR) using interpolation.
Clearly show your workings.

Total marks 30

Part C
Prepare a report in which:
1) Advise which machine to buy. Your advice should be based on the interpretation of each result from part A and B and explain if and why the decision you would make based on part A would change after the appraisal from part B. 20 marks

2) Explain limitations and advantages of implementing each technique using, if and when appropriate, the case as example and appropriate references. 20 marks

Note: Word limit for Part C is 750 words (+/-10%).

Total marks 40

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