The Prime Ministers of Angria and Avalon announced in 2015 to connect Angria and Avalon by 2021 through a high-speed rail link. The construction of the high-speed railway started in 2016 and is expected to be completed on time.
Buranda Co Ltd is the sole company that specialises in the operation of rail passenger service in both countries. The authorities of Angria and Avalon have contacted the company to operate the high-speed rail link for a period of five years (a contract of five years).
Based on information received from the authorities, Buranda Co Ltd’s accountant has made the following five-year projections:
Year 1 2 3 4 5
Ticket price ($) per journey 13 14 16 18 20
Variable Costs ($) per journey 9 10 11 12 13
Additional fixed costs $ 1 million per annum
Number of carriages per journey 8 9 11 11 12
Maximum passengers per carriage 50
Average occupancy rate per journey 50% 55% 65% 65% 70%
Average number of journeys per day 7 8 15 15 16
Number of days operating per year 360
The ticket price, variable costs and additional fixed costs have been prepared on the basis of current prices. The inflation for the ticket price and the costs are as follows:
Ticket price Variable costs Fixed costs 3% 4% 5%
If Buranda Co Ltd accepts to operate the line Angria and Avalon, the company will incur a loss of pre-tax cash flows of $ 150,000 in year one as it will have to surrender a contract. Buranda Co Ltd will have to invest in a high-tech machine that will cost $ 6 million and will be disposed for $ 1.5 million at the end of the contract. The machine is eligible for capital allowances at the rate of 20% per annum on reducing balance basis as from year one.
The tax rate is 15% and is paid one year in arrears. The nominal after-tax cost of capital of Buranda Co Ltd is 9% for investment appraisal and below is the present value for discount rate of 9%.
REQUIRED
(a) Calculate the net present value to the nearest of $ 1,000 of the contract and advise whether the project is beneficial for Buranda Co Ltd.
(b) Accounting rate of return is often employed to appraise capital project as it is considered as a quick and simple calculation. However, there are also disadvantages
associated with this method.
Discuss the disadvantages of accounting rate of return?
