32. Acaba Co
Acaba Co. is a manufacturing company that has three investment decisions for the coming year.
Investment decision 1
Six investment projects are being considered with the following details:
Project 
Initial Outlay 
Net Present Value 

$'000 
$'000 
A 
1,000 
390 
B 
1,500 
Not yet known 
C 
750 
325 
D 
1,125 
590 
E 
1,850 
840 
F 
1,300 
635 
Project B is expected to generate the following annual cash flows:
Year 
1 
2 
3 
4 

$'000 
$'000 
$'000 
$'000 
Sales income 
725 
765 
885 
612 
Costs 
145 
168 
202 
94 
Project B cash flows are before allowing for inflation of 4% per year for sales income and 5% per year for costs. Acaba Co has a nominal cost of capital of 10%.
Due to management reluctance to raise new finance, capital for investment in the above projects is currently restricted to $5m. Projects A, B, D and F are all independent, but projects C and E are mutually exclusive. All of the above projects are divisible and none can be delayed or repeated.
Investment decision 2
A number of Acaba Co’s employees have a company car. The entire company car fleet is now due for renewal and in the past, it has been replaced every four years. Management are not sure if this is the optimum length of time and feel that other fleet replacement cycles, such as every three or five years, should also be considered.
Investment decision 3
The management of Acaba Co are considering the financial viability of another project but as yet, no detailed financial information is available to perform an NPV appraisal. One of the reasons for this is that the various cash flows will be subject to a number of different rates of inflation that are very uncertain at present. For example, the selling price inflation may be no more than 2% per year whereas material cost inflation could be anything from 4% to 6% per year. The general rate of inflation is expected to differ from both of these. Management are not sure whether the appraisal could be performed by simply ignoring the inflation altogether.
Note: The $5m capital constraint outlined with investment decision 1 applies to that investment decision only and not to investment decisions 2 and 3.
Required
A. For investment decision 1:
(i) Calculate the net present value of project B; and
(ii) Given the capital constraint, calculate the optimum investment combination and the resulting net present value.
(i) Calculate the NPV of project B
Year 
1 
2 
3 
4 
Sales (inflated at 4%) 
754 
827 
996 
716 
Costs (inflated at 5%) 
152 
185 
234 
114 
Net cash flow 
602 
642 
762 
602 
DCF @ 10% 
0.909 
0.826 
0.751 
0.683 
Present Values 
547 
530 
572 
411 
Total PV 2,061
Less: Initial outlay 1,500
NPV 561
(a) (ii)
Firstly, calculate the profitability index for each project and rank.
Project 
Outlay $'000 
NPV $'000 
P. Index 
(NPV/Outlay) 
Rank 
A 
1,000 
390 
390 / 1,000 = 
0.390 
5 
B 
1,500 
561 
561 / 1,500 = 
0.374 
6 
D 
1,125 
590 
590 / 1,125 = 
0.524 
1 (highest) 
E 
1,850 
840 
840 / 1,850 = 
0.454 
3 
F 
1,300 
635 
635 / 1,300 = 
0.488 
2 
Projects C and E are mutually exclusive so cannot be done together. As all projects are divisible, the project with the highest PI will be chosen out of the two which in this case is E at 0.454, rather than C with 0.433.
Optimal combination
Rank 
Project 
% 
Capital $'000 
NPV $'000 
1 
D 
100 
1,125 
590 
2 
F 
100 
1,300 
635 
3 
E 
100 
1,850 
840 
4 
A 
72.5 
725 
283 



5,000 
2,348 
After selection of project E, only $725,000 of capital remains. Consequently, only 72.5% (725/1,000=0.725) of project A can be undertaken. This will result in only 72.5% of the NPV (0.725 x $390,000 = $283,000).
The optimum investment plan is to invest fully in projects D, F and E and only 72.5% in project A. This will yield a maximum net present value of $2,348,000