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

Three possible investment opportunities have been identified. Only £400,000 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 (i.e. cannot be scaled down) and none of them can be postponed. The following cash flows do not allow for inflation, which is expected to be 10 per cent per annum constant for the foreseeable future.

Expected net cash flows (including residual values)

Project	Initial investment £	Year 1£	Year 2£	Year 3£
A	-350,000	95,000	110,000	200,000
B	-105,000	45,000	45,000	45,000
C	-35,000	-40,000	-25,000	125,000

The company’s shareholders currently require a return of 15 per cent nominal on their investment.

Ignore taxation.

RequiredThe directors of XYZ plc wish to expand the company’s operations. However, they are not prepared to borrow at the present time to finance capital investment. The directors have therefore decided to use the company’s cash resources for the expansion programme.

Three possible investment opportunities have been identified. Only £400,000 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 (i.e. cannot be scaled down) and none of them can be postponed. The following cash flows do not allow for inflation, which is expected to be 10 per cent per annum constant for the foreseeable future.

Expected net cash flows (including residual values)

Project	Initial investment £	Year 1£	Year 2£	Year 3£
A	-350,000	95,000	110,000	200,000
B	-105,000	45,000	45,000	45,000
C	-35,000	-40,000	-25,000	125,000

The company’s shareholders currently require a return of 15 per cent nominal on their investment.

Ignore taxation.

Required

(a) (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.

(b) Discuss whether the company’s decision not to borrow, thereby limiting investment expenditure, is in the best interests of its shareholders.

 

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