- 20 Marks
FM – L2 – Q67 – Capital rationing
Determine optimal investment for Yebson Plc with GH₵800,000, assuming divisible/indivisible projects, and calculate NPV
Question
Yebson Plc is reviewing investment proposals that have been submitted by divisional managers. The investment funds of the company are limited to GH₵800,000 in the current year. Details of three possible investments, none of which can be delayed, are given below.
Project 1
An investment of GH₵300,000 in work station assessments. Each assessment would be on an individual employee basis and would lead to savings in labour costs from increased efficiency and from reduced absenteeism due to work-related illness. Savings in labour costs from these assessments in money terms are expected to be as follows:
| Year | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| Cash flows (GH₵000) | 85 | 90 | 95 | 100 | 95 |
Project 2
An investment of GH₵450,000 in individual workstations for staff that is expected to reduce administration costs by GH₵140,800 per annum in money terms for the next five years.
Project 3
An investment of GH₵400,000 in new ticket machines. Net cash savings of GH₵120,000 per annum are expected in current price terms and these are expected to increase by 3.6% per annum due to inflation during the five-year life of the machines.
Yebson Plc has a money cost of capital of 12% and taxation should be ignored.
Required:
(a) Determine the best way for Yebson Plc to invest the available funds and calculate the resultant NPV:
(i) on the assumption that each of the three projects is divisible
(ii) on the assumption that none of the projects are divisible.
(b) Explain how the NPV investment appraisal method is applied in situations where capital is rationed.
(c) Discuss the reasons why capital rationing may arise.
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