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Prepared by: Sir Saddam(ACCA)

Email: [email protected] Contact 0334-5422353

Muhamad

237

PREPARED BY: MUHAMMAD SADDAM UDDIN (ACCA)EMAIL: [email protected] CONTACT 0334-5422353

2014

Investment AppraisalSuitable for AA! "#A! ACCA! M$A! $$A andall tho%e %tudent% &ho %tudyin' finance %ub(ect.

mailto:[email protected]








Investment Appraisal

Topics List

Page

). #n*e%tment apprai%al method%

).) Paybac+ period ,-,

).2 Accountin' rate of return A//0 ,-1

).3 et pre%ent *alue P0 ,-4

)., #nternal rate of return ,-7

2. Sta'e in the capital in*e%tment pro(ect% 155

3. 6etermination of the ca%h flo&%

3.) /ele*ant ca%h flo&% 15)

3.2 onrele*ant co%t% 15)

,. Allo&in' for ta8! inflation and &or+in' capital

,.) #nflation 152

,.2 a8ation 152

,.3 9or+in' capital 153

,., eneral layout of ca%h flo& preparation 153

1. Pro(ect apprai%al and ri%+

1.) /i%+ and uncertainty 154

1.2 Probability analy%i% 154

1.3 Sen%iti*ity analy%i% 157

1., Ad(u%ted paybac+ 157

1.1 Simulation 15;

4. A%%et in*e%tment deci%ion

4.) <ea%e or buy 15-

4.2 A%%et replacement 1)2

4.3 /eplacement cycle% 1)24., Capital rationin' 1)3

23;








! Investment Appraisal "et#ods

! Pa$%ac& period

).).) Time it ta&es t#e pro'ect to pa$%ac& it% initial in*e%tment.

).).2 9hen i% u%eful=

%ee+in' to cla %ac& cas# from in*e%tment% as *ic&l$ as possi%le

commonly u%ed for initial screening of in*e%tment alternati*e%

).).3 A long pa$%ac& period i% con%idered ris&$ becau%e it relie% on ca%h flo&% that are in

the di%tant future.

).)., 6eci%ion rule:

only %elect pro(ect% &hich pa$%ac& it#in t#e speci+ied time period

c#oose %eteen options on the ba%i% of the +astest pa$%ac&

pro*ide% a meas*re o+ li*idit$

).).1 eneral approach:

,ear Cas# +los () C*m*lative cas# +los ()

5 )55!5550 )55!5550

) 25!555 ;5!5550

2 35!555 15!5550

3 ,5!555 )5!5550

, 35!555 25!555

1 ,5!555

Paybac+ period > 3 year% ? )5!55535!555

> 3.33 year% or 3 year% , month%

).).4 6i%counted paybac+ period:

,ear Cas# +lo

(000)

.isco*nted

Cas# +lo /0

(000)

C*m*lative cas#

+lo

(000)

5 2!5550 2!5550 2!5550

) 455 1,1 )!,110

2 155 ,)3 )!5,20

3 455 ,1) 1-)0

, 455 ,)5 );)0

1 355 );4 1

23;








4 255 ))3 ));

he pa$%ac& period i% about 5 $ears.

).).7 Ad*anta'e% and di%ad*anta'e% of paybac+ period

Advantages .isadvantages

#t i% %imple

#t i% u%eful in certain %ituation%:

/apidly chan'in' technolo'y

#mpro*in' in*e%tment

condition%

#t fa*our% uic+ return:

Belp% company 'ro&th

Minimie% ri%+

Ma8imie% liuidity

#t u%e% ca%h flo&%! not accountin'

profit.

#t i'nore% o*erall profitability after

the paybac+ period

#t i'nore% time *alue of money

#t i% %ub(ecti*e D no definiti*e

in*e%tment %i'nal

!2 Acco*nting 1ate o+ 1et*rn (A11)

).2.) Al%o +no&n a% /CE or /#.

).2.2 6eci%ion rule:

A// F tar'et return or hurdle rate! accept the pro(ect

a+e the pro(ect &ith the hi'he%t A//

).2.3 Calculation of A// D three *er%ion

Ann*al %asis D

A// > Profit for the year G )55H

A%%et boo+ *alue at %tart of year

hen! ta+e a*era'e of each yearI% A// to find the a*era'e A//.

Total investment %asis D

A// > A*era'e annual profit G )55H

#nitial capital in*e%ted

Average investment %asis D

23-








A// > A*era'e annual profit G )55H

A*era'e capital in*e%ted

A*era'e capital in*e%ted > #nitial in*e%tment ? Scrap *alue

2

).2., Ad*anta'e% and di%ad*anta'e% of A//


#t i% a *ic& and simple

calc*lation

#t in*ol*e% the +amiliar concept o+

a percentage ret*rn

#t loo+% at the entire pro'ect li+e

#t i% %ased on acco*nting pro+it

and not cas# +los.

#t depends on acco*nting policies

and thi% can ma&e comparison of

A// bein' di++ic*lt.

#t i% a relative meas*re rat#er

t#an an a%sol*te meas*re and

hence ta&es no acco*nt o+ t#e sie

o+ t#e investment

<i+e the paybac+ method! it

ignores t#e time val*e o+ mone$.

!3 et Present al*e (P)

).3.) P of ca%h inflo&% compare &ith the P of ca%h outflo&% to obtain a P.

).3.2 he di%count rate eual% it% co%t of capital or 9ACC.

).3.3 6eci%ion rule:

P F 5! the pro(ect i% financially *iable! i.e. accepted. P > 5! the pro(ect brea+% e*en.

P J 5! the pro(ect i% not financially *iable! i.e. re(ected.

).3., #f the company ha% to or more m*t*all$ ecl*sive pro'ects under con%ideration it

%hould c#oose t#e one it# t#e #ig#est P.

).3.1 he P 'i*e% the impact of the pro(ect on s#are#older ealt#.

All acceptable in*e%tment pro(ect %hould ha*e po%iti*e P

he mar&et val*e of the company! t#eoreticall$ at lea%t! increases %$ t#e

amo*nt o+ t#e P

2,5








he s#are price of the company %hould t#eoreticall$ increase a% &ell

b(ecti*e of maimiing t#e ealt# o+ s#are#olders i% u%ually s*%stit*ted

%$ t#e o%'ective o+ maimiing t#e s#are price o+ a compan$

).3.4 Ad*anta'e% and di%ad*anta'e% of P


Con%ider% the time *alue of money

#% an ab%olute mea%ure of return!

i.e. ab%olute increa%e in corporate

*alue

#% ba%ed on ca%h flo&% not profit%

Con%ider% the &hole life of the

pro(ect

Should lead to ma8imiation of

%hareholder &ealth

Can accommodate chan'e% in

di%count rate

Ba% a %en%ible rein*e%tment

a%%umption

Can accommodate non

con*entional ca%h flo&%

#t i% difficult to e8plain to mana'er%

and relati*ely comple8

#t reuire% +no&led'e of the co%t of

capital

).3.7 9hy P i% s*perior to ot#er met#ods=

P considers cas# +los

P con%ider% the #ole li+e of an in*e%tment pro(ect P con%ider% the time val*e o+ mone$

P i% an a%sol*te meas*re o+ ret*rn

P directly lin&s to t#e o%'ective o+ maimiing s#are#olders6 ealt#

P offer% the correct investment advice

P can accommodate c#anges in t#e disco*nt rate

P ha% a sensi%le re-investment ass*mption

P can accommodate non-conventional cas# +los

2,)








!4 Internal 1ate o+ 1et*rn (I11)

).,.) #// i% defined a% the di%count rate at &hich the P e*als ero. #n other &ord%! the

#// repre%ent% the %rea&even disco*nt rate for the in*e%tment.

).,.2 6eci%ion rule:

I11 7 cost o+ capital! pro(ect accept%

he #ig#er I11 is t#e %etter

).,.3 Step% in calculatin' the #// u%in' linear interpolation:

). Calculate t&o P at t&o different di%count rate%. 8ne mu%t be positive and

another one mu%t be negative.

2. K%in' the follo&in' formula to find the #//

#// > < ? 0. L H N N

N

H L

L−×

+

&here:

< > <o&er rate of intere%t

B > Bi'her rate of intere%t

< > P at lo&er rate of intere%t

B > P at hi'her rate of intere%t

).,., Ad*anta'e% and di%ad*anta'e% of #//


Con%ider% the time val*e o+ mone$

#% a percentage and therefore

easil$ *nderstood K%e% cas# +los not pro+its

Con%ider% the #ole li+e o+ t#e

pro'ect

Mean% a firm %electin' pro(ect%

&here the #// e8ceed% the co%t of

capital %hould increa%e

%hareholder%I &ealth.

#t i% not a meas*re of a%sol*te

increase in compan$ val*e.

#nterpolation only pro*ide% ane%timate and an accurate e%timate

reuire% the u%e of a %pread%heet

pro'ram

#t i% +airl$ complicated to calculate

on-conventional cas# +los may

'i*e ri%e to m*ltiple I11s

Can offer con+licting advice

%eteen I11 and P in the

2,2








e*aluation of mutually e8clu%i*e

pro(ect%

Ass*me cas# in+los %eing

reinvested at t#e I11 rate! thi% i%

*nrealistic &hen #// i% hi'h.

).,.1 on-conventional cas# +los

he pro(ect ha% con*entional ca%h flo&%! i.e. an initial ca%h outflo& follo&ed

by a %erie% of inflo&%.

9hen flo&% *ary from thi% they are termed noncon*entional.

9ample

he follo&in' pro(ect ha% noncon*entional ca%h flo&%:

,ear 000

5 )!-550

) ,!1-5

2 2!7310

Pro(ect L &ould ha*e t&o #//% a% %ho& in the follo&in' dia'ram.

2,3








he P rule %u''e%t% that the pro(ect i% acceptable bet&een co%t% of capital of 7H and 31H.

Suppo%e that the reuired rate on pro(ect L i% )5H and that the #// of 7H i% u%ed in

decidin' &hether to accept or re(ect the pro(ect. he pro(ect &ould be re(ected %ince it

appear% that it can only yield 7H.

he dia'ram %ho&%! ho&e*er! that bet&een rate% of 7H and 31H the pro(ect %hould be

accepted. K%in' the #// of 31H &ould produce the correct deci%ion to accept the pro(ect.

<ac+ of +no&led'e of multiple #//% could therefore lead to %eriou% error% in the deci%ion of

&hether to accept or re(ect a pro(ect.

#n 'eneral! if the %i'n of the net ca%h flo& chan'e% in %ucce%%i*e period%! the calculation%

may produce a% many #//% a% there are %i'n chan'e%. #// %hould not normally be u%ed

&hen there are noncon*entional ca%h flo&%.

2! Stages in t#e Capital Investment Pro'ects

2.) Sta'e% can be %ummaried a% follo&%:

Stages 9planation

#dentify in*e%tment

opportunitie%

Ari%e from analy%i% of %trate'ic choice! bu%ine%%

en*ironment! /6 or le'al en*ironment! etc.

Ney reuirement i% to achie*e the or'aniational

ob(ecti*e%.

Screen in*e%tment

propo%al%

Select tho%e propo%al% &ith be%t %trate'ic fit and the

mo%t appropriate u%e of economic re%ource%.

Analy%e and e*aluate

in*e%tment propo%al%

Analy%e and e*aluate &hich propo%al%0 offer the

mo%t attracti*e opportunitie% to achie*e companyob(ecti*e%! e.'. increa%e %hareholder &ealth.

#n*e%tment apprai%al play% a +ey role here! e.'.

choo%e hi'he%t P amon' different propo%al%.

Appro*e in*e%tment

propo%al%

Pa%% to rele*ant le*el of authority for appro*al.

<ar'e propo%al% appro*e by board of director%!

%maller propo%al% appro*e by di*i%ional le*el.

#mplementation /e%pon%ibility for the pro(ect i% a%%i'ned to a pro(ect

mana'er or other re%pon%ible per%on.

2,,








/e%ource% &ill be a*ailable and %pecific tar'et %hould

be %et.

Monitorin' Pro're%% mu%t be monitored to chec+ &hether there

are any bi' *ariance% and unfore%een e*ent%.

Po%tcompletion audit o facilitate or'aniational learnin' and to impro*e

future in*e%tment deci%ion%.

2,1








3! .etermination o+ t#e Cas# :los

3! 1elevant cas# +los

3.).) he follo&in' principle% %hould be applied &hen identifyin' co%t% that are rele*ant to

a period.

1elevant costs 9planation

"uture co%t% "uture co%t ari%e% a% a direct conse*ence o+ a

decision.

S*n& costs s#o*ld not %e incl*ded becau%e it i% past

and %o irrele*ant to any deci%ion.

Ca%h flo&% "uture co%t% &hich are in the form of cas# %hould be

included.

So depreciation s#o*ld %e ignored becau%e it i% not

ca%h %pendin'.

#ncremental co%t% #ncrea%e in co%t% res*lts +rom ma&ing a partic*lar

decision.

pportunity co%t% #t i% the *alue of a %ene+it +oregone a% a re%ult of

choo%in' a particular cour%e of action.

3!2 on-relevant costs

3.2.) ther non-relevant costs:

Committed costs D they are +*t*re cas# +lo %*t &ill be inc*rred an$a$!

re'ardle%% of &hat deci%ion &ill be ta+en.

Interest costs D they ha*e already been incl*ded in t#e disco*nt rate! if

counted! it &ill be do*%le co*nted.

2,4








4! Alloing +or Ta; In+lation and <or&ing Capital

4! In+lation

,.).) #nflation ha% t&o impact% on P:

Speci+ic in+lation D ca%h flo& ri%e% by the rate of inflation

=eneral in+lation D co%t of capital or di%count rate0 ri%e% by the rate of

inflation.

,.).2 /eal and money nominal0 intere%t rate

#t ha% the follo&in' relation%hip bet&een real intere%t rate and nominal intere%t

rate under "i%herI% euation.

( > i) ? ( > r) ( > #)

9here h > inflation rate

r > real intere%t rate

i > nominal intere%t rate

4!2 Taation

,.2.) a8ation ha% the follo&in' t&o effect% on ca%h flo&:

9++ects 9planation

a8 on profit% Calc*late t#e taa%le pro+its (%e+ore capital

alloances) and calculate ta8 at the rate 'i*en.

he effect of ta8ation &ill not necessaril$ occ*r int#e same $ear! often one $ear in arrears in the

e8amination.

a8 benefit% from

96A%

ormally 21H &ritin'do&n allo&ance% on plant and

machinery can be %trai'htline0

/emember the %alancing alloance or %alancing

c#arge in t#e +inal $ear!

2,7








4!3 <or&ing capital

,.3.) e& pro(ect reuire% an additional in*e%tment in &or+in' capital.

,.3.2 he treatment of &or+in' capital i% a% follo&%:

Initial investment is a cost at the start of the pro(ect! i.e. cas# o*t+lo.

#f increasing d*ring t#e pro'ect! the increase is a relevant cas# o*t+lo.

9or+in' capital i% released at t#e end of the pro(ect and treated a% cas#

in+lo.

4!4 =eneral la$o*t o+ cas# +lo preparation

,.,.) he 'eneral layout can be %ho&n a% follo&%:

Oear 0 2 3 4

000 000 000 000 000

Sale% L L L

Co%t% L0 L0 L0

peratin' ca%h flo&% L L L

Taation L0 L0 L0

Ta %ene+it o+ CAs L L L

Capital e8penditure and %crap *alue L0 L

<or&ing capital c#anges L0 L0 L0 L0 L

et ca%h flo&% L0 L L L L

6i%count factor L L L L L

Pre%ent *alue L0 L L L L

2,;








@*estion

he follo&in' draft apprai%al of a propo%ed in*e%tment pro(ect ha% been prepared for the

finance director of NM Co by a trainee accountant. he pro(ect i% con%i%tent &ith the

current bu%ine%% operation% of NM Co.

,ear 2 3 4 5

Sale% unit%yr0 215!555 ,55!555 155!555 215!555

000 000 000 000 000

Contribution )!335 2!)2; 2!445 )!335

"i8ed co%t% 1350 1420 1-40 43)0

6epreciation ,3;0 ,3;0 ,370 ,370

#ntere%t payment% 2550 2550 2550 2550

a8able profit )42 -2; )!,27 42

a8ation ,-0 27;0 ,2;0 )-0

Profit after ta8 )42 ;7- )!),- 3440 )-0

Scrap *alue 215

Afterta8 ca%h flo&% )42 ;7- )!),- ))40 )-0

6i%count at )5H 5.-5- 5.;24 5.71) 5.4;3 5.42)

Pre%ent *alue% ),7 724 ;43 7-0 )20

et pre%ent *alue > )!4,1!555 D 2!555!555 > 311!5550 %o re(ect the pro(ect.

he follo&in' information &a% included &ith the draft in*e%tment apprai%al:

). he initial in*e%tment i% 2 million

2. Sellin' price: )2unit current price term%0! %ellin' price inflation i% 1H per year

3. ariable co%t: 7unit current price term%0! *ariable co%t inflation i% ,H per year

,. "i8ed o*erhead co%t%: 155!555year current price term%0! fi8ed co%t inflation i% 4H per year

1. 255!555year of the fi8ed co%t% are de*elopment co%t% that ha*e already been incurred

and are bein' reco*ered by an annual char'e to the pro(ect

4. #n*e%tment financin' i% by a 2 million loan at a fi8ed intere%t rate of )5H per year

7. NM Co can claim 21H reducin' balance capital allo&ance% on thi% in*e%tment and

pay% ta8ation one year in arrear% at a rate of 35H per year

;. he %crap *alue of machinery at the end of the fouryear pro(ect i% 215!555

-. he real &ei'hted a*era'e co%t of capital of NM Co i% 7H per year

2,-








)5. he 'eneral rate of inflation i% e8pected to be ,Q7H per year

1e*ired

a0 #dentify and comment on any error% in the in*e%tment apprai%al prepared by the trainee

accountant. 1 mar+%0

b0 Prepare a re*i%ed calculation of the net pre%ent *alue of the propo%ed in*e%tment

pro(ect and comment on the pro(ectI% acceptability. )2 mar+%0

c0 6i%cu%% the problem% faced &hen underta+in' in*e%tment apprai%al in the follo&in'

area% and comment on ho& the%e problem% can be o*ercome:

i0 a%%et% &ith replacement cycle% of different len'th%R

ii0 an in*e%tment pro(ect ha% %e*eral internal rate% of returnR

iii0 the bu%ine%% ri%+ of an in*e%tment pro(ect i% %i'nificantly different from the

bu%ine%% ri%+ of current operation%. ; mar+%0

21 mar+%0

215








5! Pro'ect Appraisal and 1is&

5! 1is& and *ncertaint$

1.).) Since +*t*re cas# +los cannot %e predicted it# certaint$! mana'er% mu%t

con%ider ho& much confidence can be placed in the re%ult% of the in*e%tment apprai%al

proce%%. hey mu%t therefore be concerned it# t#e ris& and *ncertaint$ of a

pro(ect.

1.).2 /i%+ refer% to the %ituation &here pro%a%ilities can %e assigned to a range o+

epected o*tcomes! %o it can be *anti+ied.

1.).3 Kncertainty refer% to the %ituation &here pro%a%ilities cannot %e assigned to

epected o*tcomes! %o it i% *n*anti+ia%le. #t can onl$ %e descri%ed.

1.)., #f ri%+ and uncertainty &ere not considered! mana'er% mig#t ma&e mista&e o+

placing too m*c# con+idence in the re%ult% of in*e%tment apprai%al! or they may +ail

to monitor in*e%tment pro(ect% in order to en%ure that e8pected re%ult% are in fact

bein' achie*ed.

1.).1 Assessment o+ pro'ect ris& can al%o indicate pro'ects t#at mig#t %e re'ected as

%eing too ris&$ compared &ith e8i%tin' bu%ine%% operation%! or pro(ect% that mi'ht be

ort#$ o+ reconsideration i+ a$s o+ red*cing pro'ect ris& co*ld %e +o*nd in order

to ma+e pro(ect outcome% more acceptable.

5!2 Pro%a%ilit$ anal$sis

1.2.) #t refer% to the assessment o+ t#e separate pro%a%ilities o+ a n*m%er o+ speci+ied

o*tcomes of an in*e%tment pro(ect.

1.2.2 he P from com%inations o+ +*t*re economic conditions co*ld %e assessed and

lin&ed to t#e 'oint pro%a%ilities of tho%e combination%. he epected P could be

calculated.1.2.3 he e8pected *alue E0 i% the &ei'hted a*era'e of all po%%ible outcome%! &ith the

&ei'htin'% ba%ed on the probability e%timate%.

E > ∑ px

9here: p > the probability of an outcome

8 > the *alue of an outcome

21)








5!3 Sensitivit$ anal$sis

1.3.) Sen%iti*ity analy%i% assesses #o t#e P o+ an investment pro'ect is a++ected %$

c#anges in pro'ect varia%les. he p*rpose i% to identi+$ t#e &e$ or critical

varia%les %o that mana'ement can concern more.

1.3.2 he c#ange in one varia%le reuired to ma&e t#e P to %e ero.

1.3.3 r alternati*ely! the chan'e in P ari%in' from a fi8ed chan'e in the 'i*en pro(ect

*ariable.

1.3., Bo&e*er! %en%iti*ity analy%i% does not assess t#e pro%a%ilit$ of chan'e% in pro(ect

*ariable%.

1.3.1 A %imple approach to decidin' &hich *ariable% the P i% particularly %en%iti*e to i%

to calculate the %en%iti*ity of each *ariable:

Sen%iti*ity > P H

P of pro(ect *ariable

1.3.4 he loer t#e percentage! the more sensitive i% P to that pro(ect *ariable a% the

*ariable &ould need to chan'e by a %maller amount to ma+e the pro(ect non*iable.

5!4 Ad'*sted pa$%ac&

1.,.) Paybac+ can be ad(u%ted for ri%+:

Big#er ris& pro'ect %hould reuire %hortenin' t#e pa$%ac& period.

Puttin' the focu% on ca%h flo&% that are more certain le%% ri%+y0 becau%e they

are nearer in time.

1.,.2 6i%counted paybac+:

Ad(u%ted for ri%+ by disco*nting +*t*re cas# +los &ith a ris&-ad'*steddisco*nt rate.

he normal pa$%ac& period target can %e applied to the di%counted ca%h

flo&%! &hich &ill ha*e decrea%ed in *alue due to di%countin'.

he overall e++ect i% similar to red*cing t#e pa$%ac& period &ith

undi%counted ca%h flo&%.

212








5!5 Sim*lation

1.1.) An analy%i% of ho& c#anges in more t#an one varia%le e.'. mar+et %hare and %ale%

price0 may affect the P of a pro(ect.

@*estion 2

Kmunat plc i% con%iderin' in*e%tin' 15!555 in a ne& machine &ith an e8pected life of fi*e

year%. he machine &ill ha*e no %crap *alue at the end of fi*e year%. #t i% e8pected that

25!555 unit% &ill be %old each year at a %ellin' price of 3Q55 per unit. ariable production

co%t% are e8pected to be )Q41 per unit! &hile incremental fi8ed co%t%! mainly the &a'e% of a

maintenance en'ineer! are e8pected to be )5!555 per year. Kmunat plc u%e% a di%count rate

of )2H for in*e%tment apprai%al purpo%e% and e8pect% in*e%tment pro(ect% to reco*er their

initial in*e%tment &ithin t&o year%.

1e*ired

a0 E8plain &hy ri%+ and uncertainty %hould be con%idered in the in*e%tment apprai%al

proce%%. 1 mar+%0

b0 Calculate and comment on the paybac+ period of the pro(ect. , mar+%0

c0 E*aluate the %en%iti*ity of the pro(ectI% net pre%ent *alue to a chan'e in the follo&in'

pro(ect *ariable%:

i0 %ale% *olumeR

ii0 %ale% priceR

iii0 *ariable co%tR

and di%cu%% the u%e of %en%iti*ity analy%i% a% a &ay of e*aluatin' pro(ect ri%+.

)5 mar+%0

d0 Kpon further in*e%ti'ation it i% found that there i% a %i'nificant chance that the

e8pected %ale% *olume of 25!555 unit% per year &ill not be achie*ed. he %ale%mana'er of Kmunat plc %u''e%t% that %ale% *olume% could depend on e8pected

economic %tate% that could be a%%i'ned the follo&in' probabilitie%:

Economic %tate Poor ormal ood

Probability 5.3 5.4 5.)

Annual %ale% *olume unit%0 )7!155 25!555 22!155

Calculate and comment on the e8pected net pre%ent *alue of the pro(ect. 4 mar+%0

213








21 mar+%0

! Asset Investment .ecisions

! Lease or %*$

4.).) 6C" techniue% can al%o be u%ed to a%%e%% &hether to finance an in*e%tment &ith a

lea%e or a ban+ loan.

4.).2 umerical analy%i%

he %ene+its o+ leasing vs p*rc#asing &ith a loan0 can be a%%e%%ed by an

P approach:

Step ): the cost o+ leasing payment%! lo%t capital allo&ance% and lo%t %crap

re*enue0

Step 2: the %ene+its o+ leasing %a*in'% on loan repayment% > P of loan >

initial outlay0

Step 3: disco*nting at t#e a+ter ta cost o+ de%t

Step ,: calc*late t#e P D if po%iti*e it mean% that the lea%e i% cheaper than

the after ta8 co%t of a loan.

Alternative met#od D to eval*ate t#e P o+ t#e cost o+ t#e loan and the

P o+ t#e cost o+ t#e lease separatel$! and to c#oose t#e c#eapest option.

4.).3 "inance lea%e:

ran%fer %ub%tantially all of the ri%+% and re&ard% of o&ner%hip to le%%ee.

<e%%ee can u%e the a%%et for all or mo%t of it% u%eful economic life.

#t cannot be cancelled or &ith %e*ere financial penaltie% e*en &hen

cancelled. herefore! it i% a +ind of medium to lon'term %ource of debt

finance.

<ea%ed a%%et mu%t be capitalied to'ether &ith the amount of obli'ation%

for the lea%e payment%.4.)., peratin' lea%e:

#tI% renal a'reement and the lea%e period i% %horter than the a%%etI% u%eful

economic life.

Maintenance and %imilar co%t% are borne by the le%%or.

Cancelled &ithout penalty at %hort notice. #t can a*oid the ob%ole%cence

problem! %o %uitable for hi'htech a%%t%.

o need to be capitalied and no liabilitie% need to be reco'nied.

4.).1 Attraction% of finance lea%e for le%%ee:

21,








ot enou'h ca%h and al%o difficult to obtain ban+ loan.

#ntere%t may be c#eaper t#an a %an& loan.

Ba*in' ta relie+ %uch a% the intere%t e8pen%e% and depreciation

allo&ance but refer to the e8amination ue%tion! it may not ha*e0.

4.).4 Attraction% of operatin' lea%e for le%%ee:

o effect on a%%et% and liabilitie%! %o no increase in its gearing ratio.

Can #ave t#e *p-to-date assets at all time becau%e the le%%ee can replace

&ith no co%t.

Bi'her +lei%ilit$ &ith cancellation at s#ort notice

S*ita%le +or small companies &ho may find it di++ic*lt to raise de%t

Cheaper than borro& to buy

ffbalance %heet financin'

4.).7 Attraction% of operatin' lea%e for le%%or:

<ea%ed a%%et can be reco*ered if the le%%ee default on lea%e rental%

<e%%or can ta+e ad*anta'e of bul+ buyin'

<e%%or can ha*e acce%% to lo&er co%t finance by *irtue of bein' a much lar'er

company.

En(oy ta8 benefit% %uch a% depreciation allo&ance and other allo&able

e8pen%e%.

@*estion 3 D Lease or %*$ and capital rationing

<eamin'er #nc ha% decided it mu%t replace it% ma(or turbine machine on 3) 6ecember 255;.

he machine i% e%%ential to the operation% of the company. he company i%! ho&e*er!

con%iderin' &hether to purcha%e the machine outri'ht or to u%e lea%e financin'.

P*rc#asing t#e mac#ine o*trig#t

he machine i% e8pected to co%t 345!555 if it i% purcha%ed outri'ht! payable on 3)

6ecember 255;. After four year% the company e8pect% ne& technolo'y to ma+e the machineredundant and it &ill be %old on 3) 6ecember 25)2 'eneratin' proceed% of 25!555. Capital

allo&ance% for ta8 purpo%e% are a*ailable on the co%t of the machine at the rate of 21H per

annum reducin' balance. A full yearI% allo&ance i% 'i*en in the year of acui%ition but no

&ritin' do&n allo&ance i% a*ailable in the year of di%po%al. he difference bet&een the

proceed% and the ta8 &ritten do&n *alue in the year of di%po%al i% allo&able or char'eable

for ta8 a% appropriate.

Leasing

211








he company ha% approached it% ban+ &ith a *ie& to arran'in' a lea%e to finance the

machine acui%ition. he ban+ ha% offered t&o option% &ith re%pect to lea%in' &hich are a%

follo&%:

"inance lea%e peratin' lea%e

Contract len'th year%0 , )

Annual rental )31!555 ),5!555

"ir%t rent payable 3) 6ecember 255- 3) 6ecember 255;

=eneral

"or both the purcha%in' and the finance lea%e option! maintenance co%t% of )1!555 per year

are payable at the end of each year. All the%e rental% for both finance and operatin' option%0

can be a%%umed to be allo&able for ta8 purpo%e% in full in the year of payment. A%%ume that

ta8 i% payable one year after the end of the accountin' year in &hich the tran%action occur%.

"or the operatin' lea%e only! contract% are rene&able annually at the di%cretion of either

party. <eamin'er #nc ha% adeuate ta8able profit% to relie*e all it% co%t%. he rate of

corporation ta8 can be a%%umed to be 35H. he companyI% accountin' yearend i% 3)

6ecember. he companyI% annual after ta8 co%t of capital i% )5H.

1e*ired

a0 Calculate the net pre%ent *alue at 3) 6ecember 255;! u%in' the after ta8 co%t of

capital! for:

i0 purcha%in' the machine outri'ht

ii0 u%in' the finance lea%e to acuire the machine

iii0 u%in' the operatin' lea%e to acuire the machine.

/ecommend the optimal method. )2 mar+%0

b0 A%%ume no& that the company i% facin' capital rationin' up until 35 6ecember 255-

&hen it e8pect% to ma+e a %hare i%%ue. 6urin' thi% time the mo%t mar'inal in*e%tment pro(ect! &hich i% perfectly di*i%ible! reuire% an outlay of 155!555 and &ould

'enerate a net pre%ent *alue of )55!555. #n*e%tment in the turbine &ould reduce

fund% a*ailable for thi% pro(ect. #n*e%tment% cannot be delayed.

Calculate the re*i%ed net pre%ent *alue% of the three option% for the turbine 'i*en

capital rationin'. Ad*i%e &hether your recommendation in a0 &ould chan'e.

1 mar+%0

c0 A% their bu%ine%% ad*i%or! prepare a report for the director% of <eamin'er #nc that

214








a%%e%%e% the i%%ue% that need to be con%idered in acuirin' the turbine &ith re%pect to

capital rationin'. ; mar+%0

otal 21 mar+%0

217








!2 Asset replacement

4.2.) P can be applied to %ituation% of a%%et% replacement.

4.2.2 Compare the purcha%e co%t &ith the co%t %a*in'% or benefit%!

Co%t %a*in'% or benefit% F purcha%e co%t! replace the old one.

!3 1eplacement c$cles

4.3.) Bo& freuently %hould an a%%et be replaced= he e*ivalent ann*al cost (9AC) or

ann*al e*ivalent ann*it$ (A9A) can be u%ed for e*aluation.

EAC > P of co%t%

Annuity factor for the number of year% in the cycle

he be%t deci%ion i% to c#oose t#e option it# t#e loest 9AC.

4.3.2 #% it &orth payin' more for an a%%et that ha% a lon'er e8pected life= he e*ivalent

ann*al %ene+it (9AE) can be applied.

EA$ > P of pro(ect

Annuity factor for the life of pro(ect

he be%t deci%ion i% to c#oose t#e option it# t#e #ig#est e*ivalent ann*al

%ene+it.

@*estion 4 D 1eplacement c$cle and limitations o+ P

$read Product% <td i% con%iderin' the replacement policy for it% indu%trial %ie o*en% &hich

are u%ed a% part of a production line that ba+e% bread. i*en it% hea*y u%a'e each o*en ha%to be replaced freuently. he choice i% bet&een replacin' e*ery t&o year% or e*ery three

year%. nly one type of o*en i% u%ed! each of &hich co%t% 2,!155. Maintenance co%t% and

re%ale *alue% are a% follo&%:

Oear Maintenance per annum /e%ale *alue

) 155

2 ;55 )1!455

21;








3 )!155 ))!255

ri'inal co%t! maintenance co%t% and re%ale *alue% are e8pre%%ed in current price%. hat i%!

for e8ample! maintenance for a t&o year old o*en &ould co%t ;55 for maintenance

underta+en no&. #t i% e8pected that maintenance co%t% &ill increa%e at )5H per annum and

o*en replacement co%t and re%ale *alue% at 1H per annum. he money di%count rate i% )1H.

1e*ired

a0 Calculate the preferred replacement policy for the o*en% in a choice bet&een a t&o

year or three year replacement cycle. )2 mar+%0

b0 #dentify the limitation% of et Pre%ent alue techniue% &hen applied 'enerally to

in*e%tment apprai%al. )3 mar+%0

21 mar+%0

!4 Capital rationing

4.,.) #n a per+ect capital mar&et! a company can raise +*nds as and #en it needs them.

4.,.2 Bo&e*er! in practice! it i% not the ca%e. he capital a*ailable i% al&ay% to be limited or

rationed. here are t&o type% of rationin':

4.,.3 9ternal (#ard) capital rationin':

Cannot raise eternal +inance due to too ris&$.

:inancial ris& D the companyI% gearing may be %een a% too #ig#.

E*siness ris& D lenders may be *ncertain on the companyI% +*t*re pro+its

&hether it can meet the intere%t and principal payment%

4.,., Internal (so+t) capital rationin':

"anagers impose restrictions on the fund%. he rea%on% are a% follo&%:

Mana'er% may not ant to raise ne eternal +inance! for e8ample ot &i%h to rai%e ne& debt to increa%e future intere%t payment%

ot &i%h to i%%ue ne& euity to a*oid dilution of control.

Mana'er% may pre+er sloer organic grot# in order to remain in control of

the 'ro&th proce%% and %o avoid rapid grot#.

Mana'er% may &ant to ma+e capital in*e%tment% compete +or +*nds in order

to ee& o*t ea&er or marginal pro'ects.

4.,.1 Single period capital rationin'

/ationin' occur% &hen limits are placed +or onl$ one $ear or one period.

21-








To t$pes of %in'leperiod rationin':

.ivisi%le pro(ect% D a proportion rather than the &hole in*e%tment can

%e *nderta&en and u%e pro+ita%ilit$ inde (PI) to ran& the pro(ect for

priority.

P# > P of future ca%h flo&%

#nitial in*e%tment

Indivisi%le pro(ect% D u%e trial and error to find the affordable

combination that ma8imie% P

4.,.4 "*lti-period capital rationin'

<imit% are placed for more t#an one period! in thi% ca%e! linear

programming %hould be emplo$ed. More comple8 linear pro'rammin'

problem% reuire the u%e of computer%.

4.,.7 Practical steps to deal it# capital rationin' include:

Leasing

Enterin' into a 'oint vent*re &ith a partner

.ela$ing pro'ects to a later period

1aising ne capital if po%%ible

@*estion 5 D Capital rationing and relevant cas# +los

$a%ril plc i% re*ie&in' in*e%tment propo%al% that ha*e been %ubmitted by di*i%ional

mana'er%. he in*e%tment fund% of the company are limited to ;55!555 in the current year.

6etail% of three po%%ible in*e%tment%! none of &hich can be delayed! are 'i*en belo&.

Pro'ect

An in*e%tment of 355!555 in &or+ %tation a%%e%%ment%. Each a%%e%%ment &ould be on an

indi*idual employee ba%i% and &ould lead to %a*in'% in labour co%t% from increa%edefficiency and from reduced ab%enteei%m due to &or+related illne%%. Sa*in'% in labour co%t%

from the%e a%%e%%ment% in money term% are e8pected to be a% follo&%:

Oear ) 2 3 , 1

Ca%h flo&% 5550 ;1 -5 -1 )55 -1

Pro'ect 2

An in*e%tment of ,15!555 in indi*idual &or+%tation% for %taff that i% e8pected to reduce

admini%tration co%t% by ),5!;55 per annum in money term% for the ne8t fi*e year%.

245








Pro'ect 3

An in*e%tment of ,55!555 in ne& tic+et machine%. et ca%h %a*in'% of )25!555 per

annum are e8pected in current price term% and the%e are e8pected to increa%e by 3Q4H per

annum due to inflation durin' the fi*eyear life of the machine%.

$a%ril plc ha% a money co%t of capital of )2H and ta8ation %hould be i'nored.

1e*ired

a0 6etermine the be%t &ay for $a%ril plc to in*e%t the a*ailable fund% and calculate the

re%ultant P:

i0 on the a%%umption that each of the three pro(ect% i% di*i%ibleR

ii0 on the a%%umption that none of the pro(ect% are di*i%ible. )5 mar+%0

b0 E8plain ho& the P in*e%tment apprai%al method i% applied in %ituation% &here

capital i% rationed. 3 mar+%0

c0 6i%cu%% the rea%on% &hy capital rationin' may ari%e. 7 mar+%0

d0 6i%cu%% the meanin' of the term rele*ant ca%h flo&%I in the conte8t of in*e%tment

apprai%al! 'i*in' e8ample% to illu%trate your di%cu%%ion. 1 mar+%0

21 mar+%0

24)








Additional 9amination St$le @*estions

@*estion D <ACC; P and Pro'ect-speci+ic .isco*nt 1ate

/upab Co i% a manufacturin' company that &i%he% to e*aluate an in*e%tment in ne&

production machinery. he machinery &ould enable the company to %ati%fy increa%in'

demand for e8i%tin' product% and the in*e%tment i% not e8pected to lead to any chan'e in the

e8i%tin' le*el of bu%ine%% ri%+ of /upab Co.

he machinery &ill co%t 2Q1 million! payable at the %tart of the fir%t year of operation! and i%

not e8pected to ha*e any %crap *alue. Annual beforeta8 net ca%h flo&% of 4;5!555 per year

&ould be 'enerated by the in*e%tment in each of the fi*e year% of it% e8pected operatin' life.

he%e net ca%h inflo&% are before ta+in' account of e8pected inflation of 3H per year. #nitial

in*e%tment of 2,5!555 in &or+in' capital &ould al%o be reuired! follo&ed by incremental

annual in*e%tment to maintain the purcha%in' po&er of &or+in' capital.

/upab Co ha% in i%%ue fi*e million %hare% &ith a mar+et *alue of 3Q;) per %hare. he euity

beta of the company i% )Q2. he yield on %hortterm 'o*ernment debt i% ,Q1H per year and the

euity ri%+ premium i% appro8imately 1H per year.

he debt finance of /upab Co con%i%t% of bond% &ith a total boo+ *alue of 2 million. he%e

bond% pay annual intere%t before ta8 of 7H. he par *alue and mar+et *alue of each bond i%

)55.

/upab Co pay% ta8ation one year in arrear% at an annual rate of 21H. Capital allo&ance% ta8

allo&able depreciation0 on machinery are on a %trai'htline ba%i% o*er the life of the a%%et.

1e*ired

a0 Calculate the afterta8 &ei'hted a*era'e co%t of capital of /upab Co. 4 mar+%0

b0 Prepare a foreca%t of the annual afterta8 ca%h flo&% of the in*e%tment in nominal term%!

and calculate and comment on it% net pre%ent *alue. ; mar+%0

c0 E8plain ho& the capital a%%et pricin' model can be u%ed to calculate a pro(ect%pecific

di%count rate and di%cu%% the limitation% of u%in' the capital a%%et pricin' model in

in*e%tment apprai%al. )) mar+%0

21 mar+%0

242








@*estion F D P and Pro'ect-speci+ic Cost o+ 9*it$

CT Co i% a profitable company &hich i% financed by euity &ith a mar+et *alue of );5

million and by debt &ith a mar+et *alue of ,1 million. he company i% con%iderin' t&o

in*e%tment pro(ect%! a% follo&%.

Pro'ect A

hi% pro(ect i% an e8pan%ion of e8i%tin' bu%ine%% co%tin' 3Q1 million! payable at the %tart of

the pro(ect! &hich &ill increa%e annual %ale% by 715!555 unit%. #nformation on unit %ellin'

price and co%t% i% a% follo&%:

Sellin' price: 2.55 per unit current price term%0

Sellin' co%t%: 5.5, per unit current price term%0

ariable co%t%: 5.;5 per unit current price term%0

Sellin' price inflation and %ellin' co%t inflation are e8pected to be 1H per year and *ariable

co%t inflation i% e8pected to be ,H per year. Additional initial in*e%tment in &or+in' capital of

215!555 &ill al%o be needed and thi% i% e8pected to increa%e in line &ith 'eneral inflation.

Pro'ect E

hi% pro(ect i% a di*er%ification into a ne& bu%ine%% area that &ill co%t , million. A company

that already operate% in the ne& bu%ine%% area! U Co! ha% an euity beta of )Q1. U Co i%

financed 71H by euity &ith a mar+et *alue of -5 million and 21H by debt &ith a mar+et

*alue of 35 million.

8t#er in+ormation

CT Co ha% a nominal &ei'hted a*era'e afterta8 co%t of capital of )5H and pay% profit ta8 one

year in arrear% at an annual rate of 35H. he company can claim capital allo&ance% ta8

allo&able depreciation0 on a 21H reducin' balance ba%i% on the initial in*e%tment in both pro(ect%.

/i%+free rate of return: ,H

Euity ri%+ premium: 4H

eneral rate of inflation: ,Q1H per year

.irectors6 vies on investment appraisal

he director% of CT Co reuire that all in*e%tment pro(ect% %hould be e*aluated u%in' either

paybac+ period or return on capital employed accountin' rate of return0. he tar'et paybac+

243








period of the company i% t&o year% and the tar'et return on capital employed i% 25H! &hich i%

the current return on capital employed of CT Co. A pro(ect i% accepted if it %ati%fie% either of

the%e in*e%tment criteria.

he director% al%o reuire all in*e%tment pro(ect% to be e*aluated o*er a fouryear plannin'

period! i'norin' any %crap *alue or &or+in' capital reco*ery! &ith a balancin' allo&ance if

any0 bein' claimed at the end of the fourth year of operation.

1e*ired

a0 Calculate the net pre%ent *alue of Pro(ect A and ad*i%e on it% acceptability if the pro(ect

&ere to be apprai%ed u%in' thi% method. )2 mar+%0

b0 Critically di%cu%% the director%I *ie&% on in*e%tment apprai%al. 7 mar+%0

c0 Calculate a pro(ect%pecific co%t of euity for Pro(ect $ and e8plain the %ta'e% of your

calculation. 4 mar+%0

21 mar+%0

@*estion G D P; I11 and "aimiation o+ S#are#olders6 <ealt#

SC Co i% e*aluatin' the purcha%e of a ne& machine to produce product P! &hich ha% a %hort

product lifecycle due to rapidly chan'in' technolo'y. he machine i% e8pected to co%t )

million. Production and %ale% of product P are foreca%t to be a% follo&%:

Oear ) 2 3 ,

Production and %ale% unit%year0 31!555 13!555 71!555 34!555

he %ellin' price of product P in current price term%0 &ill be 25 per unit! &hile the *ariable

co%t of the product in current price term%0 &ill be )2 per unit. Sellin' price inflation i%

e8pected to be ,H per year and *ariable co%t inflation i% e8pected to be 1H per year. oincrea%e in e8i%tin' fi8ed co%t% i% e8pected %ince SC Co ha% %pare capacity in both %pace and

labour term%.

Producin' and %ellin' product P &ill call for increa%ed in*e%tment in &or+in' capital.

Analy%i% of hi%torical le*el% of &or+in' capital &ithin SC Co indicate% that at the %tart of each

year! in*e%tment in &or+in' capital for product P &ill need to be 7H of %ale% re*enue for that

year.

SC Co pay% ta8 of 35H per year in the year in &hich the ta8able profit occur%. <iability to ta8

24,








i% reduced by capital allo&ance% on machinery ta8allo&able depreciation0! &hich SC Co can

claim on a %trai'htline ba%i% o*er the fouryear life of the propo%ed in*e%tment. he ne&

machine i% e8pected to ha*e no %crap *alue at the end of the fouryear period.

SC Co u%e% a nominal money term%0 afterta8 co%t of capital of )2H for in*e%tment apprai%al

purpo%e%.

1 e*ired

a0 Calculate the net pre%ent *alue of the propo%ed in*e%tment in product P.

)2 mar+%0

b0 Calculate the internal rate of return of the propo%ed in*e%tment in product P.

3 mar+%0

c0 Ad*i%e on the acceptability of the propo%ed in*e%tment in product P and di%cu%% the

limitation% of the e*aluation% you ha*e carried out. 1 mar+%0

d0 6i%cu%% ho& the net pre%ent *alue method of in*e%tment apprai%al contribute% to&ard%

the ob(ecti*e of ma8imi%in' the &ealth of %hareholder%. 1 mar+%0

otal 21 mar+%0

@*estion H D P; I11 and Comparison o+ Investment Appraisal "et#ods

Charm plc! a %oft&are company! ha% de*eloped a ne& 'ame! "in'oI! &hich it plan% to launch

in the near future. Sale% of the ne& 'ame are e8pected to be *ery %tron'! follo&in' a

fa*ourable re*ie& by a popular PC ma'aine. Charm plc ha% been informed that the re*ie&

&ill 'i*e the 'ame a $e%t $uyI recommendation. Sale% *olume%! production *olume% and

%ellin' price% for "in'oI o*er it% fouryear life are e8pected to be a% follo&%.

Oear ) 2 3 ,

Sale% and production unit%0 )15!555 75!555 45!555 45!555Sellin' price V per 'ame0 V21 V2, V23 V22

"inancial information on "in'oI for the fir%t year of production i% a% follo&%:

6irect material co%t V1.,5 per 'ame

ther *ariable production co%t V4.55 per 'ame

"i8ed co%t% V,.55 per 'ame

Ad*erti%in' co%t% to %timulate demand are e8pected to be V415!555 in the fir%t year of

241








production and V)55!555 in the %econd year of production. o ad*erti%in' co%t% are e8pected

in the third and fourth year% of production. "i8ed co%t% repre%ent incremental ca%h fi8ed

production o*erhead%. "in'oI &ill be produced on a ne& production machine co%tin'

V;55!555. Althou'h thi% production machine i% e8pected to ha*e a u%eful life of up to ten

year%! 'o*ernment le'i%lation allo&% Charm plc to claim the capital co%t of the machine

a'ain%t the manufacture of a %in'le product. Capital allo&ance% &ill therefore be claimed on a

%trai'htline ba%i% o*er four year%.

Charm plc pay% ta8 on profit at a rate of 35H per year and ta8 liabilitie% are %ettled in the year

in &hich they ari%e. Charm plc u%e% an afterta8 di%count rate of )5H &hen apprai%in' ne&

capital in*e%tment%. #'nore inflation.

1e*ired

a0 Calculate the net pre%ent *alue of the propo%ed in*e%tment and comment on your

findin'%. )) mar+%0

b0 Calculate the internal rate of return of the propo%ed in*e%tment and comment on your

findin'%. 1 mar+%0

c0 6i%cu%% the rea%on% &hy the net pre%ent *alue in*e%tment apprai%al method i% preferred

to other in*e%tment apprai%al method% %uch a% paybac+! return on capital employed and

internal rate of return. - mar+%0

otal 21 mar+%0

@*estion 0 D P and .isc*ssion it# 1is& Incorporation

$/ Co ha% de*eloped a ne& confectionery line that can be %old for 1Q55 per bo8 and that i%

e8pected to ha*e continuin' popularity for many year%. he "inance 6irector ha% propo%ed

that in*e%tment in the ne& product %hould be e*aluated o*er a fouryear timehorion! e*en

thou'h %ale% &ould continue after the fourth year! on the 'round% that ca%h flo&% after four year% are too uncertain to be included in the e*aluation. he *ariable and fi8ed co%t% both in

current price term%0 &ill depend on %ale% *olume! a% follo&%.

Sale% *olume bo8e%0 le%% than ) million ) D ).- million 2 D 2.- million 3 D 3.- million

ariable co%t% per bo80 2.; 3.55 3.55 3.51

otal fi8ed co%t% 0 ) million ).; million 2.; million 3.; million

"oreca%t %ale% *olume% are a% follo&%.

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Oear ) 2 3 ,

6emand bo8e%0 5.7 million ).4 million 2.) million 3.5 million

he production euipment for the ne& confectionery line &ould co%t 2 million and an

additional initial in*e%tment of 715!555 &ould be needed for &or+in' capital. Capital

allo&ance% ta8allo&able depreciation0 on a 21H reducin' balance ba%i% could be claimed on

the co%t of euipment. Profit ta8 of 35H per year &ill be payable one year in arrear%. A

balancin' allo&ance &ould be claimed in the fourth year of operation.

he a*era'e 'eneral le*el of inflation i% e8pected to be 3H per year and %ellin' price! *ariable

co%t%! fi8ed co%t% and &or+in' capital &ould all e8perience inflation of thi% le*el. $/ Co

u%e% a nominal afterta8 co%t of capital of )2H to apprai%e ne& in*e%tment pro(ect%.

1e*ired

a0 A%%umin' that production only la%t% for four year%! calculate the net pre%ent *alue of

in*e%tin' in the ne& product u%in' a nominal term% approach and ad*i%e on it% financial

acceptability &or+ to the neare%t )!5550. )3 mar+%0

b0 Comment briefly on the propo%al to u%e a fouryear time horion! and calculate and

di%cu%% a *alue that could be placed on afterta8 ca%h flo&% ari%in' after the fourth year

of operation! u%in' a perpetuity approach. A%%ume! for thi% part of the ue%tion only! that

beforeta8 ca%h flo&% and profit ta8 are con%tant from year fi*e on&ard%! and that capital

allo&ance% and &or+in' capital can be i'nored. 1 mar+%0

c0 6i%cu%% B/EE &ay% of incorporatin' ri%+ into the in*e%tment apprai%al proce%%.

7 mar+%0

21 mar+%0

247








@*estion D P; I11; Sensitivit$ Anal$sis and Capital 1ationing

9arden Co plan% to buy a ne& machine. he co%t of the machine! payable immediately! i%

;55!555 and the machine ha% an e8pected life of fi*e year%. Additional in*e%tment in

&or+in' capital of -5!555 &ill be reuired at the %tart of the fir%t year of operation. At the

end of fi*e year%! the machine &ill be %old for %crap! &ith the %crap *alue e8pected to be 1H

of the initial purcha%e co%t of the machine. he machine &ill not be replaced.

Production and %ale% from the ne& machine are e8pected to be )55!555 unit% per year. Each

unit can be %old for )4 per unit and &ill incur *ariable co%t% of )) per unit. #ncremental

fi8ed co%t% ari%in' from the operation of the machine &ill be )45!555 per year.

9arden Co ha% an afterta8 co%t of capital of ))H &hich it u%e% a% a di%count rate in

in*e%tment apprai%al. he company pay% profit ta8 one year in arrear% at an annual rate of

35H per year. Capital allo&ance% and inflation %hould be i'nored.

1e*ired

a0 Calculate the net pre%ent *alue of in*e%tin' in the ne& machine and ad*i%e &hether the

in*e%tment i% financially acceptable. 7 mar+%0

b0 Calculate the internal rate of return of in*e%tin' in the ne& machine and ad*i%e &hether

the in*e%tment i% financially acceptable. , mar+%0

c0 i0 E8plain briefly the meanin' of the term %en%iti*ity analy%i%I in the conte8t of

in*e%tment apprai%alR ) mar+0

ii0 Calculate the %en%iti*ity of the in*e%tment in the ne& machine to a chan'e in %ellin'

price and to a chan'e in di%count rate! and comment on your findin'%. 4 mar+%0

d0 6i%cu%% the nature and cau%e% of the problem of capital rationin' in the conte8t of

in*e%tment apprai%al! and e8plain ho& thi% problem can be o*ercome in reachin' the

optimal in*e%tment deci%ion for a company. 7 mar+%021 mar+%0

24;








@*estion 2 D P; 9*ivalent Ann*al Cost; Sensitivit$ and Pro+ita%ilit$ Anal$sis

/ida' Co i% e*aluatin' t&o in*e%tment pro(ect%! a% follo&%.

Pro'ect

hi% i% an in*e%tment in ne& machinery to produce a recentlyde*eloped product. he co%t of

the machinery! &hich i% payable immediately! i% )Q1 million! and the %crap *alue of the

machinery at the end of four year% i% e8pected to be )55!555. Capital allo&ance% ta8

allo&able depreciation0 can be claimed on thi% in*e%tment on a 21H reducin' balance ba%i%.

#nformation on future return% from the in*e%tment ha% been foreca%t to be a% follo&%:

,ear 2 3 4

Sale% *olume unit%year0 15!555 -1!555 ),5!555 71!555

Sellin' price unit0 21.55 2,.55 23.55 23.55

ariable co%t unit0 )5.55 )).55 )2.55 )2.15

"i8ed co%t% year0 )51!555 ))1!555 )21!555 )21!555

hi% information mu%t be ad(u%ted to allo& for %ellin' price inflation of ,H per year and

*ariable co%t inflation of 2Q1H per year. "i8ed co%t%! &hich are &holly attributable to the

pro(ect! ha*e already been ad(u%ted for inflation. /ida' Co pay% profit ta8 of 35H per year

one year in arrear%.

Pro'ect 2

/ida' Co plan% to replace an e8i%tin' machine and mu%t choo%e bet&een t&o machine%.

Machine ) ha% an initial co%t of 255!555 and &ill ha*e a %crap *alue of 21!555 after four

year%. Machine 2 ha% an initial co%t of 221!555 and &ill ha*e a %crap *alue of 15!555 after

three year%. Annual maintenance co%t% of the t&o machine% are a% follo&%:

,ear 2 3 4Machine ) year0 21!555 2-!555 32!555 31!555

Machine 2 year0 )1!555 25!555 21!555

9here rele*ant! all information relatin' to Pro(ect 2 ha% already been ad(u%ted to include

e8pected future inflation. a8ation and capital allo&ance% mu%t be i'nored in relation to

Machine ) and Machine 2.

8t#er in+ormation

/ida' Co ha% a nominal beforeta8 &ei'hted a*era'e co%t of capital of )2H and a nominal

24-








afterta8 &ei'hted a*era'e co%t of capital of 7H.

1e*ired

a0 Calculate the net pre%ent *alue of Pro(ect ) and comment on &hether thi% pro(ect i%

financially acceptable to /ida' Co. )2 mar+%0

b0 Calculate the eui*alent annual co%t% of Machine ) and Machine 2! and di%cu%% &hich

machine %hould be purcha%ed. 4 mar+%0

c0 Critically di%cu%% the u%e of %en%iti*ity analy%i% and probability analy%i% a% &ay% of

includin' ri%+ in the in*e%tment apprai%al proce%%! referrin' in your an%&er to the

relati*e effecti*ene%% of each method. 7 mar+%0

21 mar+%0




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