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:
||Net Present Value
||Not yet known
Project B is expected to generate the following annual cash flows:
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.
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.