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# Net Present Value (NPV)

Net Present Value (NPV)

Yea
r
Property
1

Property
2
£000s £000s
0 (2,500) (2,750)
1 1,000 900
2 500 700
3 600 800
4 1,000 600
5 900 700

The cost of capital of the company is 10%
The formula for calculating Net Present Value is C n / (1+k) n -C o
Whereby;
C n represents cash inflow in period n
K is the cost of capital or discounting rate
C o represents the initial investment or cash outflow
In the case of BLC Ltd the NPV of each project is as follows.
Year Property 1 PV of property 1 Property 2 PV of property

2
£000s   £000s

0 -2,500 -2,500 -2,750 -2,750
1 1,000 909 900 818.18
2 500 413.22 700 578.51
3 600 450.79 800 601.05
4 1,000 683 600 409.81

5 900 752.36 700 434.64

Discount rate 10%
For property 1 the present values per year are determined using the formula C n /(1+k) n as follows.
Year 1 =1000/(1+10%) 1 =909
Year 2 =500/(1+10%) 2 =413.22
Year 3 =600/(1+10%) 3 =450.79
Year 4 =1000/(1+10%) 4 =683
Year 5 =900/(1+10%) 5 =752.36
The total PV for property 1 =909+413.22+450.79+683+752.36=3,208
NPV of property 1=3,208-2,500=708
For property 2 the present values per year are determined using the formula C n /(1+k) n as follows.
Year 1 =900/(1+10%) 1 =818.18
Year 2 =700/(1+10%) 2 =578.51
Year 3 =800/(1+10%) 3 =601.05
Year 4 =600/(1+10%) 4 =409.81
Year 5 =700/(1+10%) 5 =434.64
The total PV for property 2 =818.18+578.51+601.05+409.81+434.64=2842.20
NPV of property 2=2842.20-2,750=92.20
The rule of thumb is that if a project has a positive NPV it should be accepted. In this case
therefore both projects can be accepted but since the company must only accept one project then
Property 1 has a higher NPV of 708 and therefore brings more returns than project 2 whose NPV
is 92.20.

b) Decision using internal rate of return (IRR) method
IRR is normally determined using trial and error method as follows
1) Property 1
Cost of capital NPV£ will be
28% (3)
27% 27
Trial and error requires that the two figures nearest to zero are used as follows;
A required cost of capital of 28% NPV = (3)
A required cost of capital of 27% NPV = 27
The total difference = £30
The difference between 27% and28%
= (27/30) x 1% = 0.009%
The difference between 28% and 27%
= (3/30) x 1% = 0.001%
IRR of Property 1 is therefore 28% – 0.001% =27.999%.
To calculate IRR, discount rates of 28% and 27% were used.
2) Property 2
Cost of capital NPV£
11% 25
12% (40)

Trial and error requires that the two figures nearest to zero are used as follows;

A cost of capital of 12% NPV = £(40)
A cost of capital of11 % NPV = £25

The total difference = £65

The difference between 11% and12%
= (25/65) x 1% = 0.0038%

The difference between 12% and 11%
= (40/65) x 1% = 0.0062%
IRR of Project 2=> 12% – 0.062% =11.99%
To calculate IRR, discount rates of 11% and 12% were used.
Property 1 has an IRR of 27.999% which is higher than the IRR of Property 2 of 11.99%. The
decision criteria is that the property with the highest IRR should be selected which is property 1
(KIERULFF, 2012)
c) Payback period
Year Property 1 cumulative Property 2 cumulative
£000s   £000s
1 1,000 1,000 900 900.00
2 500 1500.00 700 1600.00
3 600 2100.00 800 2400.00
4 1,000 400  600 350
5 900   700

For property 1 the payback period is 3 years +400/1000=3years and 4 months
For property 2 the payback period is 3 years +350/600=3 years and 6 months

The property that the company should choose is property 1 as it has a shorter payback period
than property 2
The opportunity cost of choosing property 1 is 92.20 which represent the returns of choosing
property 2. The opportunity cost of choosing property 2 is 708 which represent the returns of
choosing property 1. It is therefore prudent for the company to choose property 1 as it maximizes
returns for shareholders and leads to the least cost. The cumulative returns for property 1 in the
five year period will be 4000 against 3700 for property 2. It therefore implies that property 1 will
earn the company higher returns in the five year period than property 2 (AVERY, FLAHERTY,
and RHEE, 2011). The company should also consider other factors that are necessarily not
financial but have an impact on the firm’s decision. These include the lease agreement with
owners of each property, regulatory requirements and competition as they all could impact on the
viability of each property in the long run. For example, if the lease agreement terms for property
1 require that the lease is renewed every year whereas that of property 2 is fixed for ten years the
company may choose to go for property 2 as its cash flows are assured over a long period.
Customer service would not be disrupted by sudden cancellation of the lease in property 1
(STEFANESCU, STEFANESCU, CIORA and BOGDANOIU, 2010).
PART B
1) The current cost is that the company has a 2% bad debt which is 500million *2%=10
million
The company has to utilize an overdraft facility of 80 million at 15% per annum. The company
pays interest of 12 million per annum.
The total cost of the current trade practice is therefore 10 million +12 million =22 million

If the company offers a 2% discount and 80% of customers take the offer sales the cost would
be as follows.
80% of 500million=400 million. This implies 400 million will be paid within 30 days. However,
since the company will have given a discount of 2% it would actually receive 400million(1- 2%=392 million. That would cost the company=8 million in discounts The difference of 100 million would be paid after 70days Bad debts would fall to 1% which would mean it would be 1% of 500 million=5 million The company will not take the overdraft facility therefore so the cost of the 2% discount would be 8 million +5 million =13 million. The annual percentage cost of a 2% discount is 13million/500million100=2.6%
2) Under the existing scheme the value of trade receivables is 500million*70%=350 million
less bad debts of 10 million =340 million.
Under the proposed scheme the value of trade receivables would be 20% of 500million=100
million less 5 million bad debts=95 million.
3) The company would benefit more by offering the discount as compared to not offering it.
Under the current arrangement, the company pays annual interest of (80 million *15%) =12
million annually to the bank for overdraft facilities. The company also has bad debts of 10 million
(2% of 500million). The total cost of the current arrangement to the company is therefore 22
million (10 million +12 million). Under the proposed arrangement, the company would not take
the overdraft facilities and so it would save 12 million that it pays as interest. It would also halve
its bad debts to 1% and the bad debts would be 5 million (500million1%). The cost of the discount of 2 % would be 400million2%=8 million. The company would cut its costs from 22
million to 13 million (8 million of discounts +5 million of bad debts). The company would thus

save 22 million -13 million =9 million by adopting the new policy. Another factor that should be
considered before a decision is made is competitor reaction to change of terms (NEWELL and
KALIS, 2010).. Once the company decides to change its trading terms competitors would react as
well as that may threaten their market share. The other factor that should be considered is the
ability of suppliers to cope with the increased demand of inputs by the company. The company
will likely require more inputs to meet increased demand. Debt collection procedures need to be
enhanced to cope with high collection of debts under the proposed arrangement (KLINE, 2011).

References

AVERY, A.E., FLAHERTY, S.M.V. and RHEE, M., (2011). Fortifying The Payback Period
Method For Alternative Cash Flow Patterns.Journal of Financial and Economic
Practice, 11(2), pp. 1-9.
KIERULFF, H., (2012). IRR: A Blind Guide. American Journal of Business Education
(Online), 5(4), pp. 417.
KLINE, A., (2011). Offering a Grace Period on Overdrafts. U.S.Banker, 121(2), pp. 14.
NEWELL, C.J. and KALIS, F.J., (2010). Treatment of Defective Merchandise Allowances May
Provide Guidance for Other Trade Discounts. The Tax Adviser, 41(6), pp. 393-394.
STEFANESCU, L., STEFANESCU, A., CIORA, I.L. and BOGDANOIU, C.,( 2010).
ECONOMIC FEASIBILITY OF THE REENGINEERING PROJECTS. Journal of
Advanced Research in Management, 1(2), pp. 120-126.