FINANCIAL MANAGEMENT COVENANT FINANCIAL CONSULTANTS

INVESTMENT APPRAISAL TECHNIQUES REVIEW QUESTIONS

1. NBAA-MAY 2013 QUESTION 1

a) With the increasing attention on food safety and food quality, the owner of food processor
plant is seeking a new processing technology that addresses these concerns. He needs to make
a decision as to whether the new processing technology is worth investing in and he has
hired you as a consultant. The new technology is expected to provide cash returns and
additional cash expenditure. The future returns and costs are shown in the table below:-

Year Cash returns TZS Cash expenditure TZS

1 6,000,000.00 800,000.00
2 6,500,000.00 920,000.00
3 6,200,500.00 760,000.00
4 5,500,000.00 750,000.00
5 7,000,000.00 820,000.00
6 6,500,000.00 920,000.00

The initial investment will cost TZS.45,000,000 with a slavage value of TZS.4,000,000 at the
end of the 6th year. The discount rate for the project is 7%.

REQUIRED

Given the time value of money, calculate the NPV of the investment and provide an investment
recommendation to the owner of the Food Processor Plant . (12 marks)

2. ACCA QN 2-JUNE 2009

PV Co is evaluating an investment proposal to manufacture Product W33, which has performed

well in test marketing trials conducted recently by the company’s research and development
division. The following information relating to this investment proposal has now been prepared.

Initial investment TZS2 million

Selling price (current price terms) TZS20 per unit
Expected selling price inflation 3% per year
Variable operating costs (current price terms) TZS8 per unit
Fixed operating costs (current price terms) TZS170,000 per year
Expected operating cost inflation 4% per year

The research and development division has prepared the following demand forecast as a result of
its test marketing trials. The forecast reflects expected technological change and its effect on the
anticipated life-cycle of Product W33.

Year 1 2 3 4
Demand (units) 60,000 70,000 120,000 45,000

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It is expected that all units of Product W33 produced will be sold, in line with the company’s
policy of keeping no inventory of finished goods. No terminal value or machinery scrap value is
expected at the end of four years, when production of Product W33 is planned to end. For
investment appraisal purposes, PV Co uses a nominal (money) discount rate of 10% per year and
a target return on capital employed of 30% per year. Ignore taxation.

Required:

(a) Identify and explain the key stages in the capital investment decision-making process,
and the role of investment appraisal in this process. (7 marks)

(b) Calculate the following values for the investment proposal:

I. Net present value;

II. Internal rate of return;
III. Return on capital employed (accounting rate of return) based on average investment;
and
IV. Discounted payback period. (13 marks)

(c) Discuss your findings in each section of (b) above and advise whether the investment
proposal is financially acceptable. (5 marks)

3. ACCA DEC 2011

Warden Co plans to buy a new machine. The cost of the machine, payable immediately, is
TZS800,000 and the machine has an expected life of five years. Additional investment in working
capital of TZS90,000 will be required at the start of the first year of operation. At the end of five
years, the machine will be sold for scrap, with the scrap value expected to be 5% of the initial
purchase cost of the machine. The machine will not be replaced.

Production and sales from the new machine are expected to be 100,000 units per year. Each unit
can be sold for TZS16 per unit and will incur variable costs of TZS11 per unit. Incremental fixed
costs arising from the operation of the machine will be TZS160,000 per year.

Warden Co has an after-tax cost of capital of 11% which it uses as a discount rate in investment
appraisal. The company pays profit tax one year in arrears at an annual rate of 30% per year.
Capital allowances and inflation should be ignored.

Required:

(a) Calculate the net present value of investing in the new machine and advise whether the
investment is financially acceptable. (7 marks)

(b) Calculate the internal rate of return of investing in the new machine and advise whether
the investment is financially acceptable. (4 marks)

(c) (i) Explain briefly the meaning of the term ‘sensitivity analysis’ in the context of
investment appraisal; (1 mark)
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(ii) Calculate the sensitivity of the investment in the new machine to a change in selling price
and to a change in discount rate, and comment on your findings. (6 marks)

(d) Discuss the nature and causes of the problem of capital rationing in the context of
investment appraisal, and explain how this problem can be overcome in reaching the optimal
investment decision for a company. (7 marks)

4. ACCA DEC 2012

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 TZS4,000,000, 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:

Year 1 2 3 4
Number of small houses sold: 15 20 15 5
Number of large houses sold: 7 8 15 15

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: Small house: Large house:

Selling price: TZS200,000 TZS350,000

Variable cost of construction: TZS100,000 TZS200,000

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 TZS1,500,000 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 TZS1,000. (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. (5Marks)
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(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)

5. NBAA-NOV 2011 QUESTION 5

(a) Mr. Ahmed is a financial analyst for General Milk Company. He is currently evaluating
the NPV of establishing a line of chocolate milk plant in Arusha. He has approached you
for advice on how to consider the following cases in the capital budgeting decision.

Case 1: As part of the evaluation, the company had paid a consulting firm TZS

9,700,000 to perform a test – marketing analysis. The expenditure was made

last year.

Case II: General Milk Company has empty warehouse in Arusha hat it is
considering seling, leasing or employing elsewhere in the business. The
company plans to use the warehouse in the envisaged project.

REQUIRED:

For each case above, explain how you would consider it in evaluating the investment
decision. ( 6 marks)

(b) Blackwood Plastic is considering an investment in a new product and seeks your advice
on the profitability of the venture. The project will require an investment of TZS 40 million
in a new machine and he use of some of the firm’s existing equipment. This equipment has
a book value of TZS 20 million but is fully depreciated for tax purposes. The alternative
use of equipment would be its sale for scrap and this could only be expected to yield TZS
1 million. As the firm has spare capacity in its existing facilities, the project would require
no investment in new buildings.

The project is expected to generate revenues of TZS 60 million for each of the next five
years after which it would be withdrawn from the market. Variable costs are expected to
TZS 36 million per annum and fixed costs TZS 4 million per annum. The machinery
purchases for this project would be sold at the end of the five years for about TZS 4
million .an investment in working capital of about TZS 6 million would also be necessary.
The new machine would be depreciated ro tax purposes on a straight-line basis over five
years.

REQUIRED: If the required rate of returns is 10 percent and the tax rate is 40 percent is
this a worthwhile project? Explain ( 9 marks)

(c) Differentiate “operating lease” from “finance lease” as sources of financing acquisition of
assets. ( 5 marks)

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PRACTICE QUESTION ON CAPITAL RATIONING

The Board of OAP Co has decided to limit investment funds to $10 million for the next year and
is preparing its capital budget. The company is considering five projects, as follows:
Initial investment Net present value
Project A $2,500,000 $1,000,000
Project B $2,200,000 $1,550,000
Project C $2,600,000 $1,350,000
Project D $1,900,000 $1,500,000
Project E $5,000,000 To be calculated
All five projects have a project life of four years. Projects A, B, C and D are divisible, and Projects
B and D are mutually exclusive. All net present values are in nominal, after-tax terms.
Project E
This is a strategically important project which the Board of OAP Co have decided must be
undertaken in order for the company to remain competitive, regardless of its financial
acceptability. Information relating to the future cash flows of this project is as follows:
Year 1 2 3 4
Sales volume (units) 12,000 13,000 10,000 10,000
Selling price ($/unit) 450 475 500 570
Variable cost ($/unit) 260 280 295 320
Fixed costs ($000) 750 750 750 750
These forecasts are before taking account of selling price inflation of 5·0% per year, variable cost
inflation of 6·0%per year and fixed cost inflation of 3·5% per year. The fixed costs are incremental
fixed costs which are associated with Project E. At the end of four years, machinery from the
project will be sold for scrap with a value of $400,000. Tax allowable depreciation on the initial
investment cost of Project E is available on a 25% reducing balance basis and OAP Co pays
corporation tax of 28% per year, one year in arrears. A balancing charge or allowance is available
at the end of the fourth year of operation.
OAP Co has a nominal after-tax cost of capital of 13% per year.
Required:
(a) Calculate the nominal after-tax net present value of Project E and comment on the financial
acceptability of this project.(14 marks)
(b) Calculate the maximum net present value which can be obtained from investing the fund
of $10 million, assuming here that the nominal after-tax NPV of Project E is zero.(5 marks)
(c) Discuss the reasons why the Board of OAP Co may have decided to limit investment funds
for the next year. (6 marks)

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