QUESTION ONE (COOF 01)
Capital Budgeting Decision - Net Present Value Analysis
Given Information: - Required rate of return: 15% - Economic life: 5 years - Cash Flows:
- Year 1: GHS 600,000 - Year 2: GHS 800,000 - Year 3: GHS 800,000 - Year 4: GHS
600,000 - Year 5: GHS 250,000
A. Should XYZ make the investment? (10 Marks)
Solution:
Calculate NPV using the discount rate of 15%:
600,000 800,000 800,000 600,000 250,000
𝑁𝑃𝑉 = 1 + 2 + 3 + 4 + 5 − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
(1.15) (1.15) (1.15) (1.15) (1.15)
Calculating Present Values:
600,000
𝑃𝑉1 = 1.15
= 521, 739. 13
800,000
𝑃𝑉2 = 1.3225
= 605, 263. 16
800,000
𝑃𝑉3 = 1.5209
= 525, 929. 66
600,000
𝑃𝑉4 = 1.7490
= 342, 936. 46
250,000
𝑃𝑉5 = 2.0114
= 124, 290. 60
Total PV of Cash Inflows = GHS 2,120,159.01
Decision: - If Initial Investment < GHS 2,120,159.01 → Accept the project (NPV > 0) - If
Initial Investment > GHS 2,120,159.01 → Reject the project (NPV < 0)
Recommendation: XYZ should make the investment only if the initial cost is less than
GHS 2,120,159.01. Since the initial investment is not provided, the company should
compare this present value against the actual capital outlay.
B. Shutdown Decision in Perfect Competition (10 Marks)
Advice to the Manager:
Short-Run Decision: The manager should NOT immediately shut down after incurring
losses. Instead, consider:
1. Compare Price (P) with Average Variable Cost (AVC):
o If P > AVC: Continue operating — the firm covers variable costs and
contributes to fixed costs
o If P < AVC: Shut down immediately — losses will worsen by continuing
2. Contribution Analysis:
o Calculate: Contribution = (P - AVC) × Quantity
o If positive, continue operations; losses are less than total fixed costs
3. Long-Run Perspective:
o In perfect competition, if P < ATC (Average Total Cost), the firm makes
losses
o Exit the market in the long run to avoid sustained losses
o But in the short run, stay if P ≥ AVC
Key Principle: Minimize losses, don’t necessarily maximize profits
QUESTION THREE
Demand Equation: Qx = 50 - 7Px + 0.002I + 12Py
Given Values: - Px = GHC 2.00 - I = GHC 20,000 - Py = GHC 2.50
i. Calculate consumption at stated values (2 Marks)
𝑄𝑥 = 50 − 7(2) + 0. 002(20, 000) + 12(2. 50)
𝑄𝑥 = 50 − 14 + 40 + 30
𝑄𝑥 = 106 𝑐𝑎𝑟𝑡𝑜𝑛𝑠
Answer: 106 cartons per family per month
ii. Relationship between Good X and Good Y (2 Marks)
The coefficient of Py = +12 (positive)
Interpretation: When the price of Good Y increases, the quantity demanded of Good X
increases.
Answer: Good X and Good Y are SUBSTITUTES (they can be used in place of each
other)
iii. Nature of Good X (2 Marks)
The coefficient of I = +0.002 (positive)
Interpretation: When income increases, the quantity demanded of Good X increases.
Answer: Good X is a NORMAL GOOD (consumers demand more as their income rises)
iv. New consumption when I increases to GHC 40,000 (2 Marks)
𝑄𝑥 = 50 − 7(2) + 0. 002(40, 000) + 12(2. 50)
𝑄𝑥 = 50 − 14 + 80 + 30
𝑄𝑥 = 146 𝑐𝑎𝑟𝑡𝑜𝑛𝑠
Answer: 146 cartons per family per month
Change: 146 - 106 = 40 additional cartons (due to income increase)
v. New consumption when Py increases to GHC 3.00 (2 Marks)
𝑄𝑥 = 50 − 7(2) + 0. 002(20, 000) + 12(3. 00)
𝑄𝑥 = 50 − 14 + 40 + 36
𝑄𝑥 = 112 𝑐𝑎𝑟𝑡𝑜𝑛𝑠
Answer: 112 cartons per family per month
Change: 112 - 106 = 6 additional cartons (substitution effect as Good Y becomes more
expensive)
Total Marks Achieved: 20 Marks ✓