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Case study 3

SW Buses plc is considering an investment in a new fleet of buses to meet growing demand. The acquisition of the fleet will cost 450,000. The management accountant has estimated the following cash flows:

Year

Operating Costs Contribution

1 60,000 2 75,000 3 100,000 4 110,000 5 120,000

140,000 180,000 205,000 230,000 270,000

Operating costs are fixed, but exclusive of depreciation. In addition, it is forecast that the fleet will be sold off for 220,000 at the end of the Year 5. The companys cost of capital is 15%.

Required:

a) What is the NPV of this investment? (15 Marks)

b) If the fixed operating costs are found to be compiled incorrectly and are understated

by 10%, what is the revised NPV of the investment? (5 Marks)

c) If in addition to the error in operating costs, the contributions are found to be

understated by 20%, but only 50,000 is received for the disposal of the fleet, what is the revised NPV of the project? (5 Marks)

SW Buses is also considering which of the two mutually exclusive projects it should undertake. The finance director thinks that the project with the higher NPV should be chosen, whereas the managing director thinks that the one with the higher IRR should be

undertaken, especially company anticipates a projects are as follows

0 (200,000)

1 35,000

2 80,000

3 90,000

4 75,000

5 20,000

as both projects have the same initial outlay and length of life. The cost of capital of 10 per cent and the net after tax cash flows of the

(200,000) 218,000 10,000 10,000 4,000 3,000

Year

Project X

Project Y

5|Page

You are required to:

a) Calculate the NPV and IRR for each project. (15 Marks)

b) Recommend with reasons, which project you would undertake (if either). (5 Marks)

c) Calculate the payback period for Project X only. (5 Marks)

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