Topic: Investment Appraisal Instructions: Gryon a software company are considering expansion. They have decided rather than rent additional space they will buy the freehold of a new office outright as they anticipate significant rental rises in the near future and perceive that interest rates are currently low. They have two potential sites in mind. The first costs £1,112,000 and the second £2,115,000. Gryon believe if they take the second site they will be able to sublet part of the premises for a rental income of £75,000 per annum for the first five years and rising to a £85,000 per annum for the next five years.
The additional cash expected to come into the business as a result of this expansion is anticipated for the next ten years to be:
Gryron’s business is cyclical they anticipate over ten years to have three low years, three average and four good years. Last years results were average unfortunately they are unsure which way the market will move next and need to consider the range of variation of their income over the next ten years in the appraisal of this project. To date they have kept all their distributable income as retained earnings and hold cash of £450,000. Their cost of capital is 12% debt/equity ratio of 50%. However interest rates may rise and they anticipate this changing. The partners that own the business plan to retire in a decade and hope to sell the building at the end of ten years. Market forecasts indicate that values could rise between 20% and 80% over this period.
Decide: If either of the projects are viable and advise on which of the buildings they should purchase. Your answer should include a discussion of the methodology with reference to appropriate literature and a comprehensive sensitivity analysis covering variation in cost of capital and change in anticipated cash.
Expetation Yr1 Yr2 Yr3 Yr4 Yr5 Yr6 Yr7 Yr8 Yr9 Yr10 High 150 150 150 175 175 175 175 200 200 200 Average 125 125 125 150 150 150 150 175 175 175 Low 100 100 100 100 125 125 125 150 150 150