AYR Co. is considering two separate projects known as ‘Aspire’ and ‘Wolf’ which are quite different but each of which has the potential to increase AYR Co.’s market share. To date $120,000 has been spent on market research into the increase in demand that can be expected for each project. The next stage is to conduct a financial appraisal to determine which project should be taken forward as AYR Co. can only afford to fund one project at this time.

Project Aspire:

This project will require the acquisition of plant and machinery costing $2,250,000 which is payable immediately. This machinery will have a scrap value of $375,000 at the end of the 5 years. There is also $140,000 working capital to be used immediately. This amount has been taken from the company’s retained profits and will be repaid at the end of the project. Cash inflows are expected to be $650,000 in year 1 rising at a rate of 7.5% per annum for years 2 to 5 inclusive. Variable costs in year 1 are expected to be $27,000 per annum and are expected to rise at 6.75% per annum. Capital allowances are available on the plant and machinery as follows:

Year 1 - 600,000

Year 2 - 390,000

Year 3 - 345,000

Year 4 - 300,000

Year 5 - 240,000

600,000 390,000 345,000 300,000 240,000

This project will expand the current product range and will appeal to existing and potential customers.

Project Wolf:

This project will require an immediate outlay of $2,250,000. This expenditure will not attract capital allowances. Annual cash inflows of $955,000 are expected to be constant for the life of the project. Material costs are expected to be $14,400 in the first year, rising at an annual inflation rate of 7.5% per annum. Other expenses are expected to be $18,000 in year 1 and these are expected to fall by 7.5% per annum over the life of the project.

To undertake Project Wolf, factory space which is currently generating rental income will need to be used for the project. The rental income, which would not have been expected to change over the five-year period, is $75,000 per annum.

This project will take the company in a new direction appealing to a different type of customer.

Additional financial information:

? Corporation tax is paid at a rate of 20% and tax is payable one year in arrears.

? The weighted average cost of capital is 10% and, unless otherwise stated, cash flows occur at the end of the year to which they relate.

? A straight line method of depreciation at a rate of 20% is applied to all noncurrent assets.

The initial investment of $2.250m, for whichever project is chosen, is significant in terms of value for AYR Co. The board of directors is considering ways to finance the investment, and will choose between, increasing equity by issuing new ordinary shares, or taking on new debt in the form of a bank loan at a fixed rate of interest.

AYR Co. is currently financed as follows:

Capital Employed $million

Equity holder funds 20

Long term debt 18

Total 38

Required:

Prepare a report to the Directors of AYR Co. which includes the following.

1. A calculation of the Net Present Value (NPV), Internal Rate of Return (IRR) and Payback Period for projects Aspire and Wolf. Detailed calculations should be included as an appendix to the report. All cash flows should be rounded to the nearest $.

2. Analysis and evaluation of the investment project options as follows:

i. A recommendation regarding which project (if any) to undertake;

ii. Justifications for your recommendation including an evaluation of the investment appraisal techniques used in task 1 above.

iii. A summary of other factors that should be considered and information that may be needed prior to making a final decision.

3. A discussion of the two sources of finance being considered by the board of AYR Co. Your report should include:

i. A description of Equity and Debt.

ii. An explanation of the costs of each source of finance.

iii. An analysis of the effect the selection of the source of finance may have on AYR Co.’s weighted average cost of capital.

iv. An assessment of the impact of the selection of finance on current and potential shareholders and lenders.