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The directors of M &R plc wish to expand the companys operations. However, they are not prepared to borrow at the present time to finance capital investment. The directors have therefore decided to use the companys cash resources for the expansion programme.

Three possible investment opportunities have been identified. Only 600,000 is available in cash and the directors intend to limit the capital expenditure over the next 12 months to this amount. The projects are not divisible and none of them can be postponed. The following cash flows do not allow for inflation, which is expected to be 12% per annum constant for the foreseeable future.

Expected net cash flows (including residual values)

Initial investment Year 1 Year 2 Year 3

Project

A -310,000 96,000 113,000 210,000

B -115,000 45,000 42,000 47,000

C -36,000 -41,000 -23,000 127,000

The companys shareholders currently require a return of 16 per cent nominal on their investment. Ignore taxation.

a) Explain how inflation affects the rate of return required on an investment project, and the distinction between a real and a nominal approach to the evaluation of an investment project under inflation.

b)

I. Calculate the expected net present value and profitability indexes of the three projects; and

II. Comment on which project(s) should be chosen for the investment, assuming the company can invest surplus cash in the money market at 10 per cent.

c) Discuss whether the companys decision not to borrow, thereby limiting investment expenditure, is in the best interests of its shareholders.

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