IB BM SL 3.8.1 Investment appraisal

[Maximum number: 8]

In 2023, WO identified two six-year investment project options that could be beneficial.
• Option 1: Research and development (R&D).
• Option 2: Open a wind farm with five windmills.

Windmills OPQ (WO)

Windmills OPQ (WO) develops and produces electrical and mechanical components for windmills. WO has developed a unique selling point/proposition (USP) because of its customization and modification services.
In 2023, WO identified two six-year investment project options that could be beneficial.
- Option 1: Research and development (R&D).
- Option 2: Open a wind farm with five windmills.

Figure for Question IB Business Management SL 3.8.1 Investment Appraisal Methods Questions question 1 — IB Business Management SL

The capital costs and forecasted cash flows for both investment projects are shown in Table 2.

$Table 2: Capital costs and expected cash flows for both investment projects (all figures in \$000s)$

Table 2: Capital costs and expected cash flows for both investment projects (all figures in \$000s)

WO's board of directors think that the forecasted cash flow for Option 2 is too low. They believe that the demand for electricity generated by windmills is likely to rise more than the current forecast assumes. Electricity prices are also increasing.

(a)

Using relevant information from Table 2, calculate:

[ 6 ]

(i)

the average rate of return (ARR) for Option 1 (show all your working);

[ 2 ]

ARR option 1 (R&D):

Investment project	Profit ( $\$000$ )	Profit per annum ( $\$000$ )	ARR
Option 1: R\mathbin{\&}D	17600 - 9600 = 8000	8000 / 6 = 1333.33	13.89%

ARR = net profit per annum / capital (outlay) cost x 100.
ARR option 1 = 1333.33 / 9600 x 100 = 13.888% = 13.89% (allow rounding).

\frac{(17600-9600)/6}{9600}\times100=13.888\%\approx13.89\%

If a candidate writes 13%, 13.8%, or 13.88%, award [1] because of incorrect rounding. Accept 13.9% or 14%.

Award [2] if a candidate provides the correct answer with workings. A correct answer must include the percentage sign (%) in the final answer or in the working.
Award [1] if a candidate who has shown workings provides a correct procedure but has made an error in calculation or the working/answer does not include the percentage sign (%).
Award [1] if a candidate does not show any working and simply writes the answer.
Award no marks [0] merely for writing the formula.

(ii)

the average rate of return (ARR) for Option 2 (show all your working);

[ 2 ]

ARR option 2 (open a wind farm with five windmills):

Investment project	Profit ( $\$000$ )	Profit per annum ( $\$000$ )	ARR
Option 2: Open a wind farm	16000 - 9000 = 7000	7000 / 6 = 1166.67	12.96%

ARR option 2 = 1166.67 / 9000 x 100 = 12.962% = 12.96% (allow rounding).

\frac{(16000-9000)/6}{9000}\times100=12.962\%\approx12.96\%

If a candidate writes 12.9%, award [1] because of incorrect rounding. Accept 13%.

Award [2] if a candidate provides the correct answer with workings. A correct answer must include the percentage sign (%) in the final answer or in the working.
Deduct [1] if no % sign. If the candidate has already lost [1] for no % sign in (b)(i), do not deduct [1] in (b)(ii) for the same error.
Award [1] if a candidate who has shown workings provides a correct procedure but has made an error in calculation or the working/answer does not include the percentage sign (%).
Award [1] if a candidate does not show any working and simply writes the answer.
Award no marks [0] merely for writing the formula.

(iii)

the payback period for Option 1 (show all your working).

[ 2 ]

Total capital cost ( $\$000$ ) for Option 1 (R&D) = 9600.
Minus cumulative net cash flow until year 4 = 7100, so amount still required = 2500.
(Amount required / net cash flow in year) x 12 = number of months.
2500 / 5000 x 12 = 0.5 x 12 = 6 months.
Payback period for Option 1 is 4 years and 6 months, or 4.5 years, or 4 1/2 years, or 54 months.

Alternative answer:

Year	Annual net cash flow	Cumulative cash flow
Year 0	( $\$9600$ )	( $\$9600$ )
Year 1	-	( $\$9600$ )
Year 2	-	( $\$9600$ )
Year 3	$\$2500$	( $\$7100$ )
Year 4	$\$4600$	( $\$2500$ )
Year 5	$\$5000$	$\$2500$

Year 5:

\frac{2500}{5000}\times12=6\text{ months}

If $\$5000$ takes 12 months, $\$2500$ takes $\$2500$ x 12 / $\$5000$ = 6 months.
Answer: payback period for Option 1 is 4 years and 6 months, or 54 months.

Award [1] for correct answer and [1] for the working shown.

(b)

Comment on whether WO should choose Option 1 or Option 2.

[ 2 ]

IB Business Management SL 3.8.1 Investment Appraisal Methods Questions question 1

Question (a)

Question (i)

Question (ii)

Question (iii)

Question (b)