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As a Business Graduate, you have been appointed by the Board as Business Planning Manager for a local SME ( Small to Medium Sized Enterprise ). To give you a little background, the Chief Executive Officer ( CEO ) of this business ( he was once the sole owner ) is a rather old fashioned “ just do it ” type of manager. He has got this far by taking risks, but the business has moved on and is a much larger organisation now   

 

The company is presently looking at a potentially large investment. This would involve an initial cash investment  in the region of £1bn, with future cash flows accruing over the next 5 years. The CEO has always seen the appropriate method of project appraisal as being by use of the Paybacktechnique.

 

With regard to this particular investment, the CEO has co-ordinated the information gathering process and presented you with the projected cash inflows and outflows. The CEO is known to be rather an optimist. You have produced the following summary appraisal:

 

£M                   Year                Year                Year                Year                Year                Year

                           0                       1                     2                      3                      4                       5

 

Investment       (1,000)

Cash Inflows                           50                    100                  400                  800                  800

 

Having been told that the company’s Cost of Capital is 20%, including a risk element, you have told the CEO that the project is marginal for the following reasons:

 

1.      The NPV of the project is positive from the numbers supplied   2. The IRR of the project is just aboutin excess of the cost of capital

 

The CEO is very keen on this project going ahead. He thinks that a Payback of less than  4 years is justification for the investment.

 

The Non –Executive Directors fully support you, but they have asked for a report from you justifying your recommendation. This report should include the following:

 

·         An explanation of the NPV method of Project Appraisal – This is really for the benefit of the CEO. He does not accept the principle of the “time value of money”

·         A reason why NPV is a better method than PAYBACK. Include here, why the £800m in year 4 is of more value to the project than the £800m in year 5

·         A demonstration of the sensitivity of the project to cashflow variations.

·         A spreadsheet showing how the NPV and IRR can be calculated using Excel. This should include a demonstration of the formulae



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