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Question 4d

Arbore Co is a large listed company with many autonomous departments operating as investment centres. It sets investment limits for each department based on a three-year cycle. Projects selected by departments would have to fall within the investment limits set for each of the three years. All departments would be required to maintain a capital investment monitoring system, and report on their findings annually to Arbore Co’s board of directors.

The Durvo department is considering the following five investment projects with three years of initial investment expenditure, followed by several years of positive cash inflows. The department’s initial investment expenditure limits are $9,000,000, $6,000,000 and $5,000,000 for years one, two and three respectively. None of the projects can be deferred and all projects can be scaled down but not scaled up.

Project Year one 
(Immediately)   
Year two Year three  Project net
present value
PDur01 $4,000,000 $1,100,000 $2,400,000 $464,000
PDur02 $800,000 $2,800,000 $3,200,000 $244,000
PDur03 $3,200,000 $3,562,000 $0 $352,000
PDur04 $3,900,000 $0 $200,000 $320,000
PDur05 $2,500,000  $1,200,000 $1,400,000 Not provided

PDur05 project’s annual operating cash flows commence at the end of year four and last for a period of 15 years. The project generates annual sales of 300,000 units at a selling price of $14 per unit and incurs total annual relevant costs of $3,230,000. Although the costs and units sold of the project can be predicted with a fair degree of certainty, there is considerable uncertainty about the unit selling price. The department uses a required rate of return of 11% for its projects, and inflation can be ignored.

The Durvo department’s managing director is of the opinion that all projects which return a positive net present value should be accepted and does not understand the reason(s) why Arbore Co imposes capital rationing on its departments. Furthermore, she is not sure why maintaining a capital investment monitoring system would be beneficial to the company


Required:

Provide a brief response to the managing director’s opinions by:

(i) Explaining why Arbore Co may want to impose capital rationing on its departments; (2 marks)
(ii) Explaining the features of a capital investment monitoring system and discussing the benefits of maintaining such a system. (4 marks)