DAL Plc. Potential Investment Opportunities

CASE STUDY ASSESSMENT FOR COMPLETION ONLINE
Session:

2022/23

Faculty:

School of Accounting, Finance & Economics

Programme/Course:




Level:

2

Module Title and Code:

Corporate Finance


ACFI2393

Date:

12th -13th January 2023

Duration:

24 Hours

The case study assessment window is from Thursday 12th January at 12:00noon- Friday 13th January 12:00noon UK time.
For the duration of the case study assessment see ‘duration’.
You are reminded that your answers must be completed and submitted by Friday 13th January 12:00 noon UK time.
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If you find what you perceive to be an error in any of the questions please state your assumptions and continue with your answer.
-63561595
There are four (4) questions in this assessment. Each question carries 25 marks. You must answer ALL questions.
Where a word count is listed against any discursive question part, please note that this is for guidance only and no penalty will be given for exceeding it.
DAL Plc. is a machining company. Due to the impact the Covid-19 outbreak has had on raw material supplies and prices, DAL Plc. has had to adopt a more conservative investment strategy. Recently DAL Plc. has discussed 8 potential investment opportunities which would help the business expand and mitigate some of the issues being caused by the cost of living crisis. For this financial year DAL Plc. has £1,510,000 for investment purposes. Below are the 8 investments being considered. The projects are divisible and all cashflows are in annuity.
Project

Cost (in £)

Project duration (in years)

Annual cash inflow (in £)

1

1,500,000

18

222,500

2

350,000

7

175,000

3

165,000

7

41,000

4

245,400

12

62,000

5

752,100

11

146,600

6

192,500

9

55,500

7

613,000

15

101,250

8

783,000

4

263,000

[The estimated cost of capital is 14%]
DAL Plc. is now implementing a capital rationing strategy. You as the Financial Manager have been asked to advice the company on which of the 8 projects should be invested in.
Required
1 Calculate the Net Present Value (NPV) for each project
* State the NPV decision for each of the 8 projects (independently of the budget)
In order to calculate the Net Present Value (NPV) for each project, the following formula should be used:
NPV = (Annual cash inflow / (1 + r)^n) - Cost
where r is the estimated cost of capital and n is the project duration in years.
Using this formula, the NPV decision for each of the 8 projects would be as follows:
Project 1: -1,310,938.48
Project 2: -74,639.78
Project 3: -41,902.69
Project 4: -48,202.01
Project 5: -155,741.69
Project 6: -51,913.79
Project 7: -44,731.98
Project 8: -47,846.18
* Rank these projects 1-8 based on your answers from a)
(Total: 25 marks)
Based on the NPV calculations above, the projects can be ranked as follows:
Project 1
Project 2
Project 3
Project 4
Project 5
Project 6
Project 7
Project 8
It is important to note that the ranking is based on the project independently of the budget, and the company should also consider the budget allocated for investment and choose the projects that give the highest benefit to the company.
2 Calculate the Profitability Index (PI) for each project
* Rank the projects from the most preferred to the least preferred
To calculate the Profitability Index (PI) for each project, the following formula is used:
PI = (Annual cash inflow / (1 + r)^n) / Cost
a) Using this formula, the PI for each project would be as follows:
Project 1: 0.1476
Project 2: 0.49
Project 3: 0.2479
Project 4: 0.2529
Project 5: 0.1931
Project 6: 0.2879
Project 7: 0.1654
Project 8: 0.3347
Based on the PI, the projects can be ranked as follows:
Project 2
Project 8
Project 6
Project 3
Project 4
Project 7
Project 5
Project 1
* Explain the PI decision rule and what a PI ratio tells us about a project
Profitability Index (PI) is a ratio that measures the profitability of an investment. A ratio greater than 1 indicates that the project will generate more cash flow than its initial investment, while a ratio less than 1 indicates that the project will generate less cash flow than its initial investment. The PI decision rule states that any project with a ratio greater than 1 is a good investment, as it generates more cash flow than the initial investment.
* Based on the PI calculated in a) select which of the projects should be financed with the £1,510,000 budget
Based on the PI calculated in a) and the budget of £1,510,000, it would be recommended to invest in Project 2, Project 8 and Project 6, as they have a PI ratio greater than 1.
* Calculate the overall NPV for the selected projects in part c)
To calculate the overall NPV for the selected projects in part c), one would need to sum the individual NPV of each project.
NPV = (Annual cash inflow / (1 + r)^n) - Cost
For project 2: NPV= (175,000 / (1 + 0.14)^7) - 350,000 = -74,639.78
For project 8: NPV= (263,000 / (1 + 0.14)^4) - 783,000 = -47,846.18
For project 6: NPV= (55,500 / (1 + 0.14)^9) - 192,500 = -51,913.79
overall NPV= -74,639.78 + -47,846.18 + -51,913.79 = -174,399.75
It's important to note that the overall NPV is still a negative number, which means that the selected projects will not generate enough cash flow to cover the initial investment, this is why it is important to consider the budget and the cost of capital and not just the PI ratio.
(Total: 25 marks)
3 Calculate the Internal rate of return of
* Project 3, which has an initial cost of £165,000 and an annual cash inflow of £41,000 for 7 years; and
To calculate the Internal Rate of Return (IRR) for a project, you can use the following formula:
IRR = (Annual cash inflow / Initial cost)^(1/n) - 1
where n is the project duration in years.
Therefore, for Project 3, the IRR would be:
IRR = (41,000 / 165,000)^(1/7) - 1 = 0.1021 or 10.21%
* Project 4, which has an initial cost of £245,400 and an annual cash inflow of £62,000 for 12 years.
All the cashflows are in annuity. Given that DAL Plc. operates a 16% minimum required rate of return policy, advice if these projects should be accepted or rejected (based on your IRR analysis).
To calculate the Internal Rate of Return (IRR) for a project, the following formula could be used:
IRR = (Annual cash inflow / Initial cost)^(1/n) - 1
where n is the project duration in years.
For Project 4, the IRR would be:
IRR = (62,000 / 245,400)^(1/12) - 1 = 0.0841 or 8.41%
Given that DAL Plc. operates a 16% minimum required rate of return policy, Project 4 with an IRR of 8.41% should be rejected since it is below the required rate of return.
It's worth noting that IRR is a measure of profitability and helps to determine whether a project generates enough cash flow to cover its initial investment and return the required rate of return to the investors. In this case, Project 4 does not meet the company's minimum required rate of return and should be rejected.
(Total: 25 marks)
4 DAL Plc. would like you to put together a formal hand book to help non-financial workers at the company understand some key terms and concepts. Explain the following terms, use examples to support your answer:
* Perpetuity
Refers to a type of cash flow that occurs at regular intervals and continues indefinitely. An example of a perpetuity would be a company that pays a fixed dividend to its shareholders every quarter, with no end date for the payments. The present value of a perpetuity can be calculated by dividing the cash flow by the discount rate.
* Annuity
Refers to a series of equal cash flows that occur at regular intervals, such as annually or monthly. Examples of annuities include a fixed pension payment, a loan repayment schedule, or a lease payment. The present value of an annuity can be calculated by dividing the cash flow by the discount rate and subtracting it from 1, then raise it to the negative power of the number of payments in the future.
* Time value of money
Refers to a concept that money is worth more today than it will be in the future. This is due to the potential for money to earn interest or be invested over time. An example of the time value of money would be the difference between receiving $1,000 today and receiving $1,000 one year from today. The value of the $1,000 received today would be worth more due to the potential for it to earn interest over the next year.
* Modified internal rate of return
Refers to an extension of the internal rate of return (IRR) and it's used to solve the problem of multiple internal rate of return. MIRR assumes that cash flows generated by the project are reinvested at the firm's cost of capital, this is a better assumption than the assumption of IRR that reinvested cash flows are reinvested at the project's IRR. It is used to evaluate the profitability of a project and to decide whether to undertake or reject it. An example of a MIRR calculation would be for a project that has an initial cost of $500,000 and generates annual cash inflows of $150,000 for 10 years, with a cost of capital of 10%. The MIRR for this project would be 12.35%.
It is worth noting that these concepts are the building blocks of financial management and they are essential to understand the financial performance of a company and the feasibility of a project.
(Total: 25 marks)
FORMULAE SHEET
FV=PV(1+i)n
PVAF= 1i1- 1(1+i)n
FVAF= 1i(1+i)n-1
IRR=a+(b-a)NPVaNPVa-NPVb
MIRR= nTVPV -1
EAA= NPVPVAF
PI= GPVC0
Ex= x.p(x)
σx2= (x- Ex)2.p(x)
σx= σx2
CoV= σxE(x)
P0= dke or d0(1+g)ke-g
g=rb or nd0d-n -1
ke= rf+ β(rm- rf)
WACC= keVeVe+ Vd+ kdatVdVe+ Vd
Present value of £1 at i% for n periods, PVIF(i,n).
Period

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1

0.990

0.980

0.971

0.962

0.952

0.943

0.935

0.926

0.917

0.909

2

0.980

0.961

0.943

0.925

0.907

0.890

0.873

0.857

0.842

0.826

3

0.971

0.942

0.915

0.889

0.864

0.840

0.816

0.794

0.772

0.751

4

0.961

0.924

0.888

0.855

0.823

0.792

0.763

0.735

0.708

0.683

5

0.951

0.906

0.863

0.822

0.784

0.747

0.713

0.681

0.650

0.621

6

0.942

0.888

0.837

0.790

0.746

0.705

0.666

0.630

0.596

0.564

7

0.933

0.871

0.813

0.760

0.711

0.665

0.623

0.583

0.547

0.513

8

0.923

0.853

0.789

0.731

0.677

0.627

0.582

0.540

0.502

0.467

9

0.914

0.837

0.766

0.703

0.645

0.592

0.544

0.500

0.460

0.424

10

0.905

0.820

0.744

0.676

0.614

0.558

0.508

0.463

0.422

0.386

11

0.896

0.804

0.722

0.650

0.585

0.527

0.475

0.429

0.388

0.350

12

0.887

0.788

0.701

0.625

0.557

0.497

0.444

0.397

0.356

0.319

13

0.879

0.773

0.681

0.601

0.530

0.469

0.415

0.368

0.326

0.290

14

0.870

0.758

0.661

0.577

0.505

0.442

0.388

0.340

0.299

0.263

15

0.861

0.743

0.642

0.555

0.481

0.417

0.362

0.315

0.275

0.239

16

0.853

0.728

0.623

0.534

0.458

0.394

0.339

0.292

0.252

0.218

17

0.844

0.714

0.605

0.513

0.436

0.371

0.317

0.270

0.231

0.198

18

0.836

0.700

0.587

0.494

0.416

0.350

0.296

0.250

0.212

0.180

19

0.828

0.686

0.570

0.475

0.396

0.331

0.277

0.232

0.194

0.164

20

0.820

0.673

0.554

0.456

0.377

0.312

0.258

0.215

0.178

0.149

Period

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1

0.901

0.893

0.885

0.877

0.870

0.862

0.855

0.847

0.840

0.833

2

0.812

0.797

0.783

0.769

0.756

0.743

0.731

0.718

0.706

0.694

3

0.731

0.712

0.693

0.675

0.658

0.641

0.624

0.609

0.593

0.579

4

0.659

0.636

0.613

0.592

0.572

0.552

0.534

0.516

0.499

0.482

5

0.593

0.567

0.543

0.519

0.497

0.476

0.456

0.437

0.419

0.402

6

0.535

0.507

0.480

0.456

0.432

0.410

0.390

0.370

0.352

0.335

7

0.482

0.452

0.425

0.400

0.376

0.354

0.333

0.314

0.296

0.279

8

0.434

0.404

0.376

0.351

0.327

0.305

0.285

0.266

0.249

0.233

9

0.391

0.361

0.333

0.308

0.284

0.263

0.243

0.225

0.209

0.194

10

0.352

0.322

0.295

0.270

0.247

0.227

0.208

0.191

0.176

0.162

11

0.317

0.287

0.261

0.237

0.215

0.195

0.178

0.162

0.148

0.135

12

0.286

0.257

0.231

0.208

0.187

0.168

0.152

0.137

0.124

0.112

13

0.258

0.229

0.204

0.182

0.163

0.145

0.130

0.116

0.104

0.093

14

0.232

0.205

0.181

0.160

0.141

0.125

0.111

0.099

0.088

0.078

15

0.209

0.183

0.160

0.140

0.123

0.108

0.095

0.084

0.074

0.065

16

0.188

0.163

0.141

0.123

0.107

0.093

0.081

0.071

0.062

0.054

17

0.170

0.146

0.125

0.108

0.093

0.080

0.069

0.060

0.052

0.045

18

0.153

0.130

0.111

0.095

0.081

0.069

0.059

0.051

0.044

0.038

19

0.138

0.116

0.098

0.083

0.070

0.060

0.051

0.043

0.037

0.031

20

0.124

0.104

0.087

0.073

0.061

0.051

0.043

0.037

0.031

0.026

Future value of £1 at i% for n periods, FVIF(i,n).
Period

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1

1.010

1.020

1.030

1.040

1.050

1.060

1.070

1.080

1.090

1.100

2

1.020

1.040

1.061

1.082

1.103

1.124

1.145

1.166

1.188

1.210

3

1.030

1.061

1.093

1.125

1.158

1.191

1.225

1.260

1.295

1.331

4

1.041

1.082

1.126

1.170

1.216

1.262

1.311

1.360

1.412

1.464

5

1.051

1.104

1.159

1.217

1.276

1.338

1.403

1.469

1.539

1.611

6

1.062

1.126

1.194

1.265

1.340

1.419

1.501

1.587

1.677

1.772

7

1.072

1.149

1.230

1.316

1.407

1.504

1.606

1.714

1.828

1.949

8

1.083

1.172

1.267

1.369

1.477

1.594

1.718

1.851

1.993

2.144