INVESTMENT APPRAISAL

Q U E STI ON 1
Argnil Co is appraising the purchase of a new machine, costing $1·5 million, to replace an existing machine which
is becoming out of date and which has no resale value. The forecast levels of production and sales for the goods
produced by the new machine, which has a maximum capacity of 400,000 units per year, are as follows:
Year 1 2 3 4
Sales volume (units/year) 350,000 380,000 400,000 400,000
The new machine will incur fixed annual maintenance costs of $145,000 per year. Variable costs are expected to be
$3·00 per unit and selling price is expected to be $5·65 per unit. These costs and selling price estimates are in
current price terms and do not take account of general inflation, which is forecast to be 4·7% per year.
It is expected that the new machine will need replacing in four years’ time due to advances in technology. The resale
value of the new machine is expected to be $200,000 at that time, in future value terms.
The purchase price of the new machine is payable at the start of the first year of the four-year life of the machine.
Working capital investment of $150,000 will already exist at the start of the four-year period, due to the operation of
the existing machine. This investment in working capital is expected to increase in nominal terms in line with the
general rate of inflation.
Argnil Co pays corporation tax one year in arrears at an annual rate of 27% and can claim 25% reducing balance
tax-allowable depreciation on the purchase price of the new machine. The company has a real after-tax weighted
average cost of capital of 6% and a nominal after-tax weighted average cost of capital of 11%.

Required:
(a) Using a nominal terms net present value approach, evaluate whether purchasing the new machine is
financially acceptable. (10 marks)

(b) Discuss the reasons why investment finance may be limited, even when a company has attractive investment
opportunities available to it. (5 marks)

(15 marks)
Q U E STI ON 2
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:
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: $200,000 $350,000
Variable cost of construction: $100,000 $200,000
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 $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.

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 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 thenearest $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)

(25 marks)

Q U ESTI ON 3
Darn Co has undertaken market research at a cost of $200,000 in order to forecast the future cash flows of an
investment project withanexpected life of fouryears, asfollows:
Year 1 2 3 4
Sales revenue ($000) 1,250 2,570 6,890 4,530
Costs ($000) 500 1,000 2,500 1,750
These forecast cash flows are before taking account of general inflation of 4·7% per year. The capital cost of the
investment project, payable at the start of the first year, will be $2,000,000. The investment project will have zero
scrap value at the end of the fourth year. The level of working capital investment at the start of each year is expected
to be 10% of the sales revenue in that year.
Capital allowances would be available on the capital cost of the investment project on a 25% reducing balance basis.
Darn Co pays tax on profits at an annual rate of 30% per year, with tax being paid one year in arrears. Darn Co has
a nominal (money terms) after-tax cost of capital of 12% per year.

Required:
(a) Calculate the net present value of the investment project in nominal terms and comment on its financial
acceptability. (12 marks)

(b) Calculate the net present value of the investment project in real terms and comment on its financial
acceptability. (7 marks)

(c) Explain ways in which the directors of Darn Co can be encouraged to achieve the objective of maximisation
of shareholder wealth. (6 marks)

(25 marks)
Q U E STI ON 4
Spot Co is considering how to finance the acquisition of a machine costing $750,000 with an operating life of five
years. There are two financing options.
Option 1
The machine could be leased for an annual lease payment of $155,000 per year, payable at the start of each year.
Option 2
The machine could be bought for $750,000 using a bank loan charging interest at an annual rate of 7% per year.
At the end of five years, the machine would have a scrap value of 10% of the purchase price. If the machine is bought,
maintenance costs of $20,000 per year would be incurred.
Taxation must be ignored.
Required:
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 (a) Evaluate whether Spot Co should use leasing or borrowing as a source of finance, explaining
the evaluation method which you use. (10 marks)
Q U ESTI ON 5

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 Eis 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)
Q U E STI ON 6
Hraxin Co is appraising an investment project which has an expected life of four years and which will not be repeated.
The initial investment, payable at the start of the first year of operation, is $5 million. Scrap value of $500,000 is
expected to arise at the end of four years.
There is some uncertainty about what price can be charged for the units produced by the investment project, as this
is expected to depend on the future state of the economy. The following forecast of selling prices and their
probabilities has been prepared:
Future economic state Weak Medium Strong
Probability of future economic state 35% 50% 15%
Selling price in current price terms $25 per unit $30 per unit $35 per unit
These selling prices are expected to be subject to annual inflation of 4% per year, regardless of which economic state
4 [P.T.O.
 prevail in the future.
Forecast sales and production volumes, and total nominal variable costs, have already been forecast, as follows:
Year 1 2 3 4
Sales and production (units) 150,000 250,000 400,000 300,000
Nominal variable cost ($000) 2,385 4,200 7,080 5,730
Incremental overheads of $400,000 per year in current price terms will arise as a result of undertaking the investment
project. A large proportion of these overheads relate to energy costs which are expected to increase sharply in the
future because of energy supply shortages, so overhead inflation of 10% per year is expected.
The initial investment will attract tax-allowable depreciation on a straight-line basis over the four-year project
life. The rate of corporation tax is 30% and tax liabilities are paid in the year in which they arise. Hraxin Co has
traditionally used a nominal after-tax discount rate of 11% per year for investment appraisal.

Required:
a) Calculate the expected net present value of the investment project and comment on its financial acceptability.
(9 marks)

b) Critically discuss if sensitivity analysis will assist Hraxin Co in assessing the risk of the investment project.
(6 marks)

(15 marks)

Q U ESTI ON 7
Degnis Co is a company which installs kitchens and bathrooms to customer specifications. It is planning to invest
$4,000,000 in a new facility to convert vans and trucks into motorhomes. Each motorhome will be designed and
built according to customer requirements. Degnis Co expects motorhome production and sales in the first four years
of operation to be as follows.
Year 1 2 3 4
Motorhomes produced and sold 250 300 450 450
The selling price for a motorhome depends on the van or truck which is converted, the quality of the units installed
and the extent of conversion work required. Degnis Co has undertaken research into likely sales and costs of different
kinds of motorhomes which could be selected by customers, as follows:
Motorhome type Basic Standard Deluxe
Probability of selection 20% 45% 35%
Selling price ($/unit) 30,000 42,000 72,000
Conversion cost ($/unit) 23,000 29,000 40,000
Fixed costs of the production facility are expected to depend on the volume of motorhome production as follows:
Production volume (units/year) 200–299 300–399 400–499
Fixed costs ($000/year) 4,000 5,000 5,500

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 Degnis Co pays corporation tax of 28% per year, with the tax liability being settled in the year in which it arises. The
company can claim tax allowable depreciation on the cost of the investment on a straight-line basis over ten years.
Degnis Coevaluates investment projectsusing anafter-taxdiscount rate of 11%.

Required:
(a) Calculate the expected net present value of the planned investment for the first four years of operation.
(7 marks)

(b) After the fourth year of operation, Degnis Co expects to continue to produce and sell 450 motorhomes per year
for the foreseeable future.

Required:
Calculate the effect on the expected net present value of the planned investment of continuing to produce and
sell motorhomes beyond the first four years and comment on the financial acceptability of the planned
investment. (3 marks)

(c) Critically discuss the use of probability analysis in incorporating risk into investment appraisal. (5 marks)

(15 marks)

Q U ESTI ON 8
Vyxyn Co is evaluating a planned investment in a new product costing $20m, payable at the start of the first year
of operation. The product will be produced for four years, at the end of which production will cease. The
investment project will have a terminal value of zero. Financial information relating to the investment project is as
follows:
Year 1 2 3 4
Sales volume (units/year) 440,000 550,000 720,000 400,000
Selling price ($/unit) 26·50 28·50 30·00 26·00
Fixed cost ($/year) 1,100,000 1,121,000 1,155,000 1,200,000
These selling prices have not yet been adjusted for selling price inflation, which is expected to be 3·5% per year. The
annual fixed costs are given above in nominal terms.
Variable cost per unit depends on whether competition is maintained between suppliers of key components. The
purchasing department has made the following forecast:
Competition Strong Moderate Weak
Probability 45% 35% 20%
Variable cost ($/unit) 10·80 12·00 14·70
The variable costs in this forecast are before taking account of variable cost inflation of 4·0% per year.
Vyxyn Co can claim tax-allowable depreciation on a 25% per year reducing balance basis on the full investment cost
of $20m and pays corporation tax of 28% per year one year in arrears.
It is planned to finance the investment project with an issue of 8% loan notes, redeemable in ten years’ time. Vyxyn
Co has a nominal after-tax weighted average cost of capital of 10%, a real after-tax weighted average cost of capital
of 7% and a cost of equity of 11%.

Required:
(a) Discuss the difference between risk and uncertainty in relation to investment appraisal. (3
marks)

(b) Calculate the expected net present value of the investment project and comment on its
financial acceptability and on the risk relating to variable cost. (9 marks)

(c) Critically discuss how risk can be considered in the investment appraisal process.(8 marks)

(20 arks)
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Q U E STI ON 9
Yehowa –Da Company Ltd is considering investing in an ice cream plant to operate
for the next four years. The plant will cost GHC5,000 and is expected to have no
residual value. Capital Allowance, at a rate of 20% per annum will be available in
respect of the expenditure. Revenue from the plant will be GHC7,000 per year for
the first two years and GHC5,000 thereafter. Incremental costs will be GHC4,000
per annum throughout the period.

The company’s cost of capital is 10% and pays corporate tax at 28% to the year. Cash flows will be
received or paid in the year in which they relate.

Required:

a) Calculate the tax saved through the capital allowance and show the savings
arise. (3 marks)

b) Advise Yehowa –Da Company Ltd on whether or not to proceed with the

investment in the ice cream plant. (4 marks)

Q U E STI ON 1 0
a) Kwame after his National Service and with no hope of securing a job in the formal
sector has decided to run a taxi service. The following forecast has been made for
the operation of a service between Abisim and Sunyani.
i) Revenue totaling GH¢300 a week for 52 weeks in a year. This is net of
fuel and other variable costs.
ii) Tyres; four pieces for a year at GH¢120 per unit.
iii) Maintenance and servicing; GH¢120 per month.
iv) Salaries GH¢3,000 per year
v) Insurance GH¢350 per year

The net cash flow will increase at 5% per annum for the next five years due to inflation. The cost
of the vehicle is estimated at GH¢28,000. The project appears quite profitable based on the NPV
criteria using the Government policy rate of 26%. However the banks are offering rates far higher
than the policy rate.

Required:
You are to calculate the break-even rate for the project. (10 marks)

Q U E STI ON 1 1
Agyasco Ltd, a software company has developed a new game “Lando” which it plans to
launch in the near future. Sales volumes, production volumes and selling prices for
“Lando” over its four-year life are expected to be as follows:
 Year 1 2 3 4
Sales and production 150,000 70,000 60,000 60,000
Selling price (GH¢ per 25 24 23 22

Financial information on “Lando” for the first year of production is as follows: Direct
material cost GH¢5.4 per game
Other variable production cost GH¢6.00 per game
Fixed costs GH¢4.00 per game.

Advertising costs to simulate demand are expected to be GH¢650,000 in the first year of production
and GH¢100,000 in the second year of production. No advertising costs are expected in the third
and fourth years of production. Fixed costs represent incremental cash fixed production overheads.
“Lando” will be produced on a new production machine costing GH¢800,000. Although this
production machine is expected to have a useful life of up to 10 years, Government legislation allows
Agyasco Ltd to claim the capital cost of the machine against the manufacture of a single product.
Capital allowances will therefore be claimed on a straight-line basis over four years.

Agyasco Ltd pays tax on profit at a rate of 30% per annum and tax liabilities are settled in the year
in which they arise. Agyasco Ltd uses an after-tax discount rate of 10% when appraising new capital
investments. Ignore inflation.

Required:
Calculate the net present value of the proposed investment and comment on your
findings.
(10 marks)

Q U E STI ON 1 2
The Maintenance Manager of Prudence Ltd insists that management should maintain
an old equipment that had been used for 5 years and is fully depreciated rather
than buy a new one. The old equipment has a current operating cost of
GH¢53,000.00 per annum. The operating cost of the equipment is expected to
increase at 5% every year over the next four years, with a sale value of
GH¢6,500.00 in the fifth year.

The Maintenance Manager has proposed, that a new system with enhanced technology to reduce
operating cost to GH¢32,000.00 for the next three years and GH¢33,600.00 for the fourth and fifth
years be introduced. The new equipment will cost GH¢60,000.00 and when introduced, a redundancy
cost of GH¢25,000.00 will be paid, with the old equipment sold for GH¢12,000.00. The sale value of
the new equipment will be GH¢10,200.00 after its five years’ useful life.

Required:
Using Net Present Value (NPV) method of capital appraisal with 20% cost of capital, advice
management on which option Prudence Ltd should go for. (10 marks)

Q U E STI ON 1 3

Mawuena Ltd, a manufacturer of building materials has recently suffered falling demand due to
economic recession, and thus has unutilised capacity. Management has identified an
opportunity to produce designer ceramic tiles for the home improvement market. It has
already paid GH¢1.5 million for development expenditure, market research and feasibility
studies.
A new machine, with a useful life of four years could be bought at GH¢6.5million, payable immediately. The
scrap value of the machine is expected to be 5% of the cost recoverable a year after the end of the project.

The research and development division has prepared the following demand forecast:
Year 1 2 3 4
Demand (units) 110,000 130,000 150,000 145,00

The selling price is GH¢50 per box (at today’s price). Estimated operating costs, largely based on
experience are as follows:

Cost per box of tiles (at today’s price) GH¢

In addition to the initial cost of machinery, investment in working capital of GH¢0.2 million will be required
in year two. Mawuena Ltd pays tax one year in arrears at an annual rate of 30% on returns from the project.
Mawuena Ltd shareholders required a nominal return of 14% per annum after tax, which includes allowance
for generally expected inflation of 5.55% per annum. (Ignore Capital Allowance).

Required:
Assess the financial desirability of this venture in real terms, computing the net present
value offered by the project. (14marks)

Q U E STI ON 1 4
Hukportie Ltd is a manufacturer of product “Okwada” which is sold for GH¢5 per unit.
Variable costs of production are currently GH¢3 per unit, and fixed costs excluding
depreciation is GH¢350,000. The current machine which was purchased for GH¢120,000
has a written down value of GH¢20,000 and a resale value of GH¢12,000. This can however
be used for the next four years.
A new machine is available which would cost GH¢90,000. This could be used to make product “Okwada”
for a variable cost of only GH¢2.50 per unit. Fixed costs, however, would increase by GH¢7,500 per annum
as a direct consequence of purchasing the machine. The machine would have an expected life of 4 years and
a resale value after that time of GH¢8,000. Sales of product Okwada are estimated to be 75,000 units per
annum. Hukportie limited expects to earn at least 12% per annum from its investments. Taxation and
depreciation should be ignored.

Required:
Advise whether Hukportie Ltd should purchase the new machine. (10 marks)

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