Flyers plc operates public transport services in major cities in the United Kingdom (UK). The company uses the accounting rate of return (ARR) and payback methods to support investment decision...

Flyers plc operates public transport services in major cities in the United Kingdom

(UK). The company uses the accounting rate of return (ARR) and payback

methods to support investment decision making. You are a Senior Finance

Manager at Flyers plc.
The company intends to bid for new five-year contracts to operate bus services in

either Edinburgh, UK, or Newcastle upon Tyne, UK. Both contracts require

the successful bidder to pay a franchise fee to secure the contract and to invest in

a new fleet of buses. Sufficient funding is available to finance only one of these

options.

Edinburgh Newcastle

£000 £000
Franchise fee (year 0) 8,700 7,950
New buses (year 0) 4,120 3,890
Scrap value (year 5) 110 95
Forecast net cash inflows
Year 1 3,780 3,500
Year 2 4,150 3,850
Year 3 4,550 4,200
Year 4 5,120 5,150
Year 5 4,900 4,950Page 12 of 14
[2044]
Assume that all cash flows occur at the end of the respective year.
The company’s approach to investment appraisal was discussed at a recent

meeting of Flyers plc’s senior executive team. Changying Simmonds, Director of

Marketing at Flyers plc, is keen to understand the nature of investment

decisions. Changying has commented:
These decisions appear to have particular characteristics. We need to

understand why investment decisions are of importance to the business:

this will help us to appreciate if our approach to investment appraisal is

appropriate.
Travis van Riemsdyk, Chief Operating Officer at Flyers plc, has highlighted that the

internal rate of return (IRR) method can be of use in investment appraisal. Travis

has commented:
Like other investment appraisal methods, the IRR has both advantages and

disadvantages. I would like to know more about the strengths and

weaknesses of the IRR.
Required:
a. Calculate the payback for both the Edinburgh and Newcastle

upon Tyne contracts.
b. Critically evaluate the payback technique.
c. Advise Flyers plc’s senior executive team on the comments

made by Changying Simmonds and Travis van Riemsdyk. Your

advice should include an explanation of the characteristics of

investment appraisal decisions and the advantages and

disadvantages of the IRR.