Evaluation of mutually exclusive projects using alternative appraisal methods Stadler is an ambitious young executive who has recently been appointed to the position of financial director of Paradis...

BERLIN BOILER COMPANY
1
BERLIN BOILER COMPANY

Stadler is an ambitious young executive who has recently been appointed to the position of
Finance Director of the Berlin Boiler Company (BBC), a small engineering company. Stadler
egards this appointment as a temporary one, enabling him to gain experience before moving to a
larger organisation. His intention is to leave BBC in three years’ time, with its value standing high.
As a consequence, he is particularly concerned that the reported profits of BBC should be as high
as possible in his third and final year with the company.
The BBC has €350m available for investment and the directors are considering ways of using
these funds. Three projects (A, B and C) are being considered, each involving the immediate
purchase of equipment costing €350m. For technical reasons only one of the three projects can
e undertaken and the equipment for each project will have a useful life equal to that of the
project, with no scrap value. Stadler favours project C because it is expected to show the highest
accounting profit in the third year. However, he does not wish to reveal his real reasons for
favouring project C and so, in his report to the chairman, he recommends project C because it
shows the highest internal rate of return. The following summary is taken from his report:
Net Cash flows (€m) - per annum
Internal
ate of
eturn
Project 0 1 2 3 4 5 6 7 8 %
A -350 100 110 104 112 138 160 180 - 27.5
B -350 40 100 210 260 160 - - - 26.4
C -350 200 150 240 40 - - - - 33.0
The chairman of the company is accustomed to projects being appraised in terms of payback and
accounting rate of return, and he is consequently suspicious of the use of internal rate of return
as a method of project selection. Accordingly, the chairman has asked for an independent report
on the choice of project. The company’s cost of capital is 20% pre-tax and a policy of straight-line
depreciation is used to write off the cost of equipment in the financial statements.
You should prepare the report required by the chairman. Be sure to include calculations of both
the payback and accounting rate of return of each project as well as any other calculations to
think relevant.
The BBC works on decision models on a pre-tax basis so taxation should be ignored.
Optional extra assignment
Discuss the assumptions about the reactions of the stock market that are implicit in Stadler’s
choice of project C.
2
BERLIN BOILER COMPANY
Supporting Schedule to Report
a) Paybacks (€m)

Project A
3 years’ cash = 314 shortfall = 36
4 years’ cash = 426 surplus = 76
Payback = 3 +
36
112
= 3.3 years
Project B
3 years’ cash = 350 exactly
Payback = 3 years
Project C
2 years’ cash = 350 exactly
Payback = 2 years
) Accounting Rates of Return
Define ARR =
average annual profits
average investment
Project (€m)
A B C
Total cash flow
Depreciation to write-off
904
350
770
350
630
350
Total profit 554 420 280
Year of life of project 7 5 4
Average profit 79 84 70
Average investment
=
350 0
2

175
175
175
 ARR = 79 84 70
175 175 175
= 45% p.a. = 48% p.a. = 40% p.a.
c) Net Present value of Projects @ 20% p.a. Cost of Capital
€M
Project A -350 + 100 (1/(1.20)) + 110 (1/(1.20)
2
) + 104 (1/(1.20)
3
) + 112 (1/(1.20)
4
)
+ 138 (1/(1.20)
5
) + 160 (1/(1.20)
6
) + 180 (1/(1.2)
7
) = 83
Project B -350 + 40 (1/(1.20)) + 100...