QUESTION TWENTY
SC Co is evaluating the purchase of a new machine to produce product P, which has a short
product life-cycle due to rapidly changing technology. The machine is expected to cost K1
million. Production and sales of product P are forecast to be as follows:
Year 1 2 3 4
Production and sales (units/year) 35,000 53,000 75,000 36,000
The selling price of product P (in current price terms) will be K20 per unit, while the variable
cost of the product (in current price terms) will be K12 per unit. Selling price inflation is
expected to be 4% per year and variable cost inflation is expected to be 5% per year. No
increase in existing fixed costs is expected since SC Co has spare capacity in both space and
labour terms.
Producing and selling product P will call for increased investment in working capital. Analysis
of historical levels of working capital within SC Co indicates that at the start of each year,
investment in working capital for product P will need to be 7% of sales revenue for that year.
SC Co pays tax of 30% per year in the year in which the taxable profit occurs. Liability to tax
is reduced by capital allowances on machinery (tax-allowable depreciation), which SC Co can
claim on a straight-line basis over the four-year life of the proposed investment. The new
machine is expected to have no scrap value at the end of the four-year period.
SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal
purposes.
Required:
(a) Calculate the net present value of the proposed investment in product P. (12 marks)
(b) Calculate the internal rate of return of the proposed investment in product P. (3 marks)
(c) Advise on the acceptability of the proposed investment in product P and discuss the
limitations of the evaluations you have carried out. (5 marks)
(d) Discuss how the net present value method of investment appraisal contributes towards
the objective of maximising the wealth of shareholders. (5 marks)
(Total: 25 marks)
SOLUTION
Workings
(1) Annual Capital Allowance = Capital expenditure/ project’s life
= K1,000,000/ 4 years
= K250,000 per annum
Annual Tax saved = Capital allowance x Tax rate
= K250,000 x 30%
= K75,000
(2) Nominal Sales Revenue
Years Price Units Sales Revenue
K K
1 K20 (1.04) 20.80 35,000 728,000
2 K20 (1.04)^2 21.63 53,000 1,146,390
3 K20 (1.04)^3 22.50 75,000 1,687,500
1
4 K20 (1.04)^4 23.40 36,000 842,400
(3) Variable costs in nominal terms
Years Cost Units Variable Cost
K K
1 K12 (1.05) 12.60 35,000 441,000
2 K12 (1.05)^2 13.23 53,000 701,190
3 K12 (1.05)^3 13.89 75,000 1,041,750
4 K12 (1.05)^4 14.59 36,000 525,240
(4) Working Capital
Years Investment Change
K K
0 (7% x K728,000) 50,960 (50,960)
1 (7% x K1,146,390) 80,247 (29,287)
2 (7% x K1,687,500) 118,125 (37,878)
3 (7% x K842,400) 58,968 59,157
4 0 58,968
(5) Discounted cash flows
Year 1 Year 2 Year 3 Year 4
K K K K
Sales Revenue (W2) 728,000 1,146,390 1,687,500 842,400
Variable costs (W3) (441,000) (701,190) (1,041,750) (525,240)
287 287,000 445,200 645,750 317,160
Taxation at 30% (86,100) (133,560) (193,725) (95,148)
Tax saved on CA (W1) 75,000 75,000 75,000 75,000
Post tax operating cash flows 275,900 386,640 527,025 297,012
Working Capital (W4) (29,287) (37,878) 59,157 58,968
Net Cash inflows 246,613 348,762 586,182 355,980
DCF at 12% 0.893 0.797 0.712 0.636
Present Values 220,225 277,963 417,362 226,403
(a) Net Present Value
K K
Sum of Present Values (W5) 1,141,953
Less initial outlay
Capital expenditure 1,000,000
Working capital investment (W4) 50,960
(1,050,960)
Net Present Value 90,993
2
(b) Calculation of internal rate of return
Year 1 Year 2 Year 3 Year 4
K K K K
Net Cash inflows 246,613 348,762 586,182 355,980
DCF at 20% 0.833 0.694 0.579 0.482
Present Values 205,429 242,041 339,399 171,582
Net Present Value
Sum of Present Values 958,451
Less initial outlay (1,050,960)
Net Present Value (92,509)
Internal Rate of Return
= a + [NPVa/ (NPVa – NPVb) x (b – a)]
= 12% + [90,993/(90,993 – (-92,509)) x (20% - 12%)]
= 12% + [90,993/183,502 x 8%]
= 12% + 3.967%
= 16%
(c) The proposed investment in product P produces a positive net present value of K90,993.
On the basis of the net present value method, the project is acceptable. The internal rate
of return of 16% is greater than the cost of capital. Based on the internal rate of return, the
project is also acceptable. Therefore, the proposed investment in product P is financially
acceptable.
However, the evaluation carried out assumes that there will be no incremental fixed costs
as there is spare capacity. This spare capacity may be applicable in the first year but not
also in the third year when production volume is more than double that of the first year. It
would be necessary to incorporate fixed costs in the evaluation.
It has also been assumed that selling price inflation and variable cost inflation will be
constant per annum over the four year period. In reality, inflation rates are not constant
per year. It would be necessary to obtain forecast inflation rates from the relevant
government authorities so that potential impact of what the government has provided can
be assessed.
Lastly, it has been assumed that all units produced will be sold and therefore the cash
flows depend on this fact. This may not be possible in reality. It would be necessary to
assess what the impact on cash flows would be if some of the units produced could not be
sold.
(d) The net present value method of investment appraisal contributes towards the objective
of shareholder wealth maximization in two ways.
If a company invests in a project that produces a positive net present value, that company’s
market value increases by the amount of the positive net present value. Since the number
of issued shares remains unchanged, the share price increases. In this way, shareholder
wealth will have been delivered through the capital gain.
3
In order to discount future cashflows, the company’s weighted average cost of capital is
used. If this is the case, a positive net present value represents a surplus after satisfying
the required rates of return for all the financiers. Out of this surplus, a company may pay
out dividends to shareholders. In this way, shareholder wealth would be delivered through
the dividend yield.
ADDITIONAL REQUIREMENT
(e) Calculate the following for the proposed investment in product P
(i) Accounting rate of return based on initial investment
(ii) Payback period to one decimal place
(iii) Discounted payback period to one decimal place
ADDITIONAL SOLUTION
(i) Accounting Rate of Return
(1) Total profit over the four year project life
Sum of pre-tax operating cash flows K
(287,000 + 445,200 + 645,750 + 317,160) 1,695,110
Less depreciation (1,000,000)
Total profit over the four year period 695,110
(2) Average Annual Profit = Total Profit/ Project’s life
= K695,110/ 4 years
= K173,778
(3) Accounting Rate of Return
= Average Annual Profit/ Initial Investment x 100%
= K173,778 (W2)/ K1,050,960 x 100%
= 16.5%
(ii) Payback Period
Year 1 Year 2 Year 3 Year 4
K K K K
Net Cash inflows 246,613 348,762 586,182 355,980
Cumulative net cash inflows 246,613 595,375
Payback period
= 2 + (1,050,960 – 595,375)/ 586,182
= 2 + 0.777
= 2.8 years
4
(iii) Discounted payback period
Year 1 Year 2 Year 3 Year 4
K K K K
Present Values 220,225 277,963 417,362 226,403
Cumulative present values 220,225 498,188 915,550
Discounted payback period
= 3 + (1,050,960 – 915,550)/ 226,403
= 3 + 0.598
= 3.6 years