Blue Shipping wants to invest Euros 100,000,000 in a new vessel to take advantage of the growing demand for sea transport of consignments over the next 5 years. At the end of 5 years the liner can be sold for Euros 20,000. The table below summarise the basic calculation over the 5 year period.
|Time to…….t5||Item description||Amount (000 Euros)|
|Today = to||Cost of liner||100,000|
|Year 1= t1||Operating profit before depreciation||20,000|
|Year 2 = t2||Operating profit before depreciation||40,000|
|Year 3 = t3||Operating profit before depreciation||60,000|
|Year 4 = t4||Operating profit before depreciation||60,000|
|Year 5 = t5||Operating profit before depreciation||20,000|
|Year 5 = t5||Disposal proceeds from the liner||20,000|
For purposes of simplification, the following assumptions are made for the appraisal of this investment.
- Operating profit before depreciation equals the net amount of cash inflow.
- Working capital which is made up of inventories, trade receivables and trade payables remain constant.
- No wages are paid.
- Sales revenues and expenses are all paid at year end. Although not strictly true, this is a practical assumption.
Your manager would like some reassurance before making this financial commitment and has asked you to evaluate the annual inflow and outflow from this investment. Using the Accounting Rate of Return (ARR) calculate the average operating profit generated by the investment as a percentage of the average investment made over the useful life of the vessel.
- What is the average annual operating profit (AAOP) generated by the vessel using a straight-line depreciation over the 5 years period?
- What is the average investment (AI)?
- Explain the advantages and disadvantages of ARR as a method of appraising capital investment.
After obtaining the ARR, your manager asked you to use a different appraisal method, namely the Pay-back period method (PP) to calculate the time it will take for this initial investment to be repaid out of the net cash inflows it will generate.
- Demonstrate at which point the investment will start to generate positive cash flow and discuss the merits of pay-back period as a method of appraising capital decision
Having completed an appraisal of the investment of 100,000,000 Euros in a new vessel using the ARR and the PP methods, you are informed that Senior Management have still not made a decision yet. You are required to evaluate the effect of the acquisition of the new vessel on Blue Shipping cash flow considering each of the following options:
- Before evaluating the two options, describe the cash flow structure including its relationship with the Profit and Loss account and the Balance Sheet, and explain why the two options presented will have an effect on the cash flow.
- Option 1: Borrow Euros 100,000,000 over 10 years from the bank at a flat rate of 5%.
- Option 2: Charter at the cost of Euros 10,000,000 per year with bunker and other related costs (staff, insurance etc.) of Euros 5,000,000 per year.
Question3: Discuss other alternative sources of finance that Blue Shipping could consider and why you should recommend them to the Senior Management of the company.
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