BQK Co, a house-building company, plans to build 100 houses on a development site over the next four years. The purchase cost of the development site is $4,000,000, payable at the start of the first year of construction. Two types of house will be built, with annual sales of each house expected to be as follows:
Houses are built in the year of sale. Each customer finances the purchase of a home by taking out a long-term personal loan from their bank. Financial information relating to each type of house is as follows:
Selling prices and variable cost of construction are in current price terms, before allowing for selling price inflation of 3% per year and variable cost of construction inflation of 4·5% per year.
Fixed infrastructure costs of $1,500,000 per year in current price terms would be incurred. These would not relate to any specific house, but would be for the provision of new roads, gardens, drainage and utilities. Infrastructure cost inflation is expected to be 2% per year.
BQK Co pays profit tax one year in arrears at an annual rate of 30%. The company can claim capital allowances on the purchase cost of the development site on a straight-line basis over the four years of construction.
BQK Co has a real after-tax cost of capital of 9% per year and a nominal after-tax cost of capital of 12% per year. New investments are required by the company to have a before-tax return on capital employed (accounting rate of return) on an average investment basis of 20% per year.
Required:
(a) Calculate the net present value of the proposed investment and comment on its financial acceptability. Work to the nearest $1,000. (13 marks)
(b) Calculate the before-tax return on capital employed (accounting rate of return) of the proposed investment on an average investment basis and discuss briefly its financial acceptability. (5 marks)
(c) Discuss the effect of a substantial rise in interest rates on the financing cost of BQK Co and its customers, and on the capital investment appraisal decision-making process of BQK Co. (7 marks)