Question

discount 1 UL We e to fall by 60 per cent for the project to become we can use the IRR to say tilde U discount rate would have to fall by 60 per worthwhile and our decision to change. on the production of catalytic converters Activity 19.3 Li-Lo Ltd has just completed a feasibility study on the production of catalyti for car engines. The study cost £32,000 and Li-Lo is now pois The study cost $32,000 and Li-Lo is now poised to develop a prototype Teo Ltd has agreed to fund the development and will pay Li-Lo £50,000 at the each of the next five years, in exchange for which it will acquire the results and the right to use them Li-Lo will need to buy a specialist machine for £36,000 payable immediately. Other costs are: 1. Labour: £20,000 for the first year, increasing thereafter by 10 per cent per year, 2. Materials: £8,000 for the first year, increasing thereafter by £1,000 per year. The scrap value of the specialist machine is expected to be £10,000 at the end of the fifth year. It is company policy to depreciate fixed assets over five years using the straight-line method. Li-Lo's cost of capital is 20 per cent per year. This morning, Li-Lo received an offer of £20,000 from Heng Ltd for the rights to the result of the feasibility study. Required a. Advise Li-Lo whether to accept Teo's or Heng's offer. Give calculations to support your advice. b. What is the minimum annual payment from Teo that would make the two offers equally attractive to Li-LO?

I didn't understand how they solved b. and where this 2.9991 came from?

Answer 1

According to the question part b. We have to determine the annual payment from teo would equal attractive to £20000 offer from hang hence npv of teo must be equal to the bid of £20000 from hang.

Difference between npv of teo and hang bid is £1848(20000-18152) npv of 18152 is calculated in part a of question.

Net present value of teo 5 annual instalment is (50000*5*2.991) 149550

2.991 is PVAF of 20% of 5 years you can find it in PVAF TABLE and also Calculate by adding NPV of 5 years of 20%

Teo npv must be equal to= (149550+1848)£151398

Let us assume teo paid x as amount installment annually to get the above NPV hence

X*2.991= £151398

X= 151398/2.991 = £50618 approx

Hence teo had to pay £50618 annually to meet the equal attractive offer to Li-lio

Here PVAF= present value annuity factor

And NPV= Net present value