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CIBG PROFESSIONAL EXAMINATION

FOR APRIL 2020

LEVEL 3
FINANCIAL REPORTING, PLANNING AND
ANALYSIS

TOPIC (20 MARKS)

INVESTMENT APPRAISAL

WRITTEN BY: TARGET

TEL: 0507380935 / 0546738172
 INVESTMENT APPRAISAL (CAPITAL BUDGETING)
Capital and revenue expenditure
Capital expenditure refers to expenditure incurred to acquire a new non-current assets,
improving existing non-current assets or investment in new business. This expenditure
should be recognised (capitalised) on the financial position. Capital expenditure
initiatives are often referred to as investment projects, or ‘capital projects’ and this
normally create long term assets with a long-term benefits
In contrast, Revenue expenditure refers to the expenditure incurred just to maintain the
even flow of the economic benefits of Non-current assets. This expenditure is normally
expensed in the statement of profit or loss as and when incurred. The benefits last within
one financial year.

A distinction might possibly be made between:

1. Essential capital expenditure incurred to replace (improve) worn-out assets and
maintain operational capability

2. Discretionary capital expenditure on new business initiatives that are intended to

develop the business make a suitable financial return on the investment.

Examination questions usually focus on discretionary capital expenditure.

Investment appraisal
Before capital expenditure projects are undertaken, they should be assessed and
evaluated. As a general rule, projects should not be undertaken unless:
1. They are expected to provide a suitable financial return, and
2. The investment risk is acceptable.
Investment appraisal is the evaluation of proposed investment projects involving capital
expenditure. The purpose of investment appraisal is to make a decision about whether
the capital expenditure is worthwhile and whether the investment project should be
undertaken.

Capital budgeting
Capital expenditure by a company should provide a long-term financial return, and
spending should therefore be consistent with the company’s long-term corporate and
financial objectives. Capital expenditure should therefore be made with the intention of
implementing chosen business strategies that have been agreed by the board of directors.
Many companies have a capital budget, and capital expenditure is undertaken within the
agreed budget framework and capital spending limits. For example, a company might
have a five-year capital budget, setting out in broad terms its intended capital expenditure
for the next five years. This budget should be reviewed and updated regularly, typically
each year.

Within the long-term capital budget, there should be more detailed spending plans for the
next year or two.

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1. Individual capital projects that are formally approved should be included within the
capital budget.

2. New ideas for capital projects, if they satisfy the investment appraisal criteria and are
expected to provide a suitable financial return, might be approved provided that they
are consistent with the capital budget and overall spending limits.

Investment appraisal and capital budgets

Investment appraisal therefore takes place within the framework of a capital budget and
strategic planning. It involves
 Generating capital investment proposals in line with the company’s strategic objectives.

 Forecasting relevant cash flows relating to the project

 Evaluating the projects

 Implementing projects which satisfy the company’s criteria for deciding whether the
project will earn a satisfactory return on investment

 Monitoring the performance of investment projects to ensure that they perform in line
with expectations.

Features of investment projects

Many investment projects have the following characteristics:

The project involves the purchase of an asset with an expected life of several years, and
involves the payment of a large sum of money at the beginning of the project. Returns on
the investment consist largely of net income from additional profits over the course of the
project’s life.

1. The asset might also have a disposal value (residual value) at the end of its useful life.
2. A capital project might also need an investment in working capital. Working capital
also involves an investment of cash.
Alternatively a capital investment project might involve the purchase of another
business, or setting up a new business venture. These projects involve an initial capital
outlay, and possibly some working capital investment. Financial returns from the
investment might be expected over a long period of time, perhaps indefinitely.

Methods of investment appraisal

There are four methods of evaluating a proposed capital expenditure project. Any or all of
the methods can be used, but some methods are preferable to others, because they provide
a more accurate and meaningful assessment.
The four methods of appraisal are:

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1. Accounting rate of return (ARR) method

2. Payback method

3. Discounted cash flow (DCF) methods:

i) Net present value (NPV) method

ii) Internal rate of return (IRR) method

Each method of appraisal considers a different financial aspect of the proposed capital
investment.

Definition of Accounting Rate Return

The accounting rate of return (ARR) from an investment project is the accounting profit,
usually before interest and tax, as a percentage of the capital invested. It is similar to
return on capital employed (ROCE), except that whereas ROCE is a measure of financial
return for a company or business as a whole, ARR measures the financial return from
specific capital project. The essential feature of ARR is that it is based on accounting
profits, and the accounting value of assets employed

If accounting rate of return (ARR) is used to decide whether or not to make a capital
investment, we calculate the expected annual accounting return over the life of the
project. The financial return will vary from one year to the next during the project;
therefore we have to calculate an average annual return.
If the ARR of the project exceeds a target accounting return, the project would be
undertaken. If its ARR is less than the minimum target, the project should be rejected and
should not be undertaken.
Unfortunately, a standard definition of accounting rate of return does not exist. There are
two main definitions:

 Average annual profit as a percentage of the average investment in the project

 Average annual profit as a percentage of the initial investment.

NOTE, the first formula is the most preferable except otherwise stated or the residual
value is not given.
You would normally be told which definition to apply. If in doubt, assume that capital
employed is the average amount of capital employed over the project life.

From the above definitions the formulas can be express as following

First formula.
ARR = average annual profit /average investment
where, Average annual profit =total annual profits / number of years
Average investment = (initial investment + Residual value) / 2
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Second formula
ARR = average annual profit / initial investment

Decision rule for the ARR method

 Single projects
The decision rule for a single capital investment appraisal using the ARR method
is that accept capital project with higher expected ARR than a minimum target
ARR or minimum acceptable ARR.
Alternatively the minimum target or acceptable ARR can be assumed as the
company’s overall (internal) ROCE
 Multiple projects
The decision rule for multiple projects is that accept project with highest ARR as
compared with other projects and the minimum target ARR or ROCE

Advantages and disadvantages of using the ARR method

The main advantages of the ARR are that:
1 It is fairly easy to understand. It uses concepts that are familiar to business
managers, such as profits and capital employed.
2 t is easy to calculate.

However, there are significant disadvantages with the ARR method.

3 It is based on accounting profits, and not cash flows. However the accounting profit
can be manipulated with subjective accounting policies.

4 Accounting profits are an unreliable measure. For example, the annual profit and
the average annual investment can both be changed simply by altering the rate of
depreciation and the estimated residual value.

5 The ARR method ignores the timing of the accounting profits. However, the
timing of profits is significant, because the sooner the cash returns are received, the
sooner they can be reinvested to increase returns even more.

6 The ARR is a percentage return, relating the average profit to the size of the
investment. It does not give us an absolute value of the return. However the
absolute return can be significant.

7 When using the ARR method for investment appraisal, a decision has to be made
about what the minimum target ARR should be. There is no rational economic
basis for setting a minimum target for ARR. Any such minimum target accounting
return is a subjective target, with no economic or investment significance.

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 8 It does not takes into consideration the risk associated with the accounting profits
by discounting these profits

Example 1: Accounting rate of return

Target Publications is considering a project which requires an investment of GHS
450,000 in piece of equipment. The equipment will last five years with a residual value of
GHS 50,000.
The expected annual profits before depreciation are:
Year
1. GHS160,000
2. GHS140,000
3. GHS200,000
4. GHS125,000
5. GHS160,000
Target requires a minimum accounting rate of return (or a target ROCE) of 26% from
projects of this type. ARR is measured as average annual profits as a percentage of the
average investment.
Should the project be undertaken?

Solution
Total annual profits before depreciation

YEAR GHS

1 160,000
2 140,000
3 200,000
4 125,000
5 160,000
total profits 785,000
total depreciation (450,000 - -400,000
50,000)
total profits after deprecation 385,000
number of years 5
average annual profit (385,000 / 77,000
5yrs)
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YEAR GHS

Average investment
(450,000 + 50,000) / 2 250,000
Accounting rate of return
(77,000 / 250,000) * 100 30.8%

Hence the project should be accepted, since the ARR is higher than the minimum target
ARR or the ROCE

Payback Period Method of Capital Investment Appraisal

Definition of payback period

It is the length of time before the cash invested in a project will be recovered (paid back)
from the net cash returns from the investment project. Payback is measured by cash
flows, not profits.

For example, suppose that a project will involve capital expenditure of GHS120,000 and
the annual net cash returns from the project will be GHS45,000 each year for five years.
The expected payback period is: GHS120.000/GHS45,000 = 2.67 years.

Decision rule for the payback method

 single Projects
Accept project that can payback

 multiple Projects
Accept the project with the shortest payback period.

Advantages and disadvantages of the payback method

The advantages of the payback method for investment appraisal are as follows:
 Simplicity – The payback is easy to calculate and understand.
 This method uses cash flows but not accounting profits. Investments are about
investing cash to earn cash returns. In this respect, the payback method is better
than the ARR method.
 Payback can be used to eliminate projects that will take too long to pay back.

The disadvantages of the payback method are as follows:

 It ignores all cash flows after the payback period, and so ignores the total cash
returns from the project. This is a significant weakness with the payback method.
 It ignores the timing of the cash flows during the payback period.

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  The payback period is duration in which the capital investment will be recovered. It
does not give us an absolute value of the return. However the absolute return can be
significant.
 It does not takes into consideration the risk associated with the cash flows by
discounting these cash flows

Example 2: Payback period

Target Publications is considering a new project requiring a capital outlay of
GHS140,000 on equipment and an investment of GHS20,000 in working capital. The
project will have a four year life with an estimated residual value of GHS 5,000. The
project is expected to earn the following net cash receipts:
Year
1. GHS90,000
2. GHS48,000
3. GHS90,000
4. GHS25,000
Should the investment be undertaken?

Solution
Note that ‘now’ is usually referred to as ‘Time 0’.
The investment in working capital should be included as an outflow of cash at the
beginning of the project. This is because when there is an increase in working capital,
cash flows are lower than cash profits by the amount of the increase.
Similarly when working capital is reduced to ₦0 at the end of the project, the reduction is
added to cash flows because when there is a reduction in working capital, cash flows are
higher than cash profits by the amount of the reduction.

year cashflow Net balance

GHS GHS

o (160,000) (160,000)
1 40,000 (120,000)
2 50,000 (70,000)
3 90,000 0
4 60,000

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Payback period = 2 + 70000/90,000 = 2.78 years OR

Payback period = 2yrs + (70000/90,000)×12months = 2years and 9 months

Workings
Year o cashflow = GHS140,000 + GHS20,000 =GHS160,000
Year 4 cash flow = GHS5,000 + GHS35,000+ GHS20,000 = GHS60,000

Now try this

Example 3: Payback period and ARR
Target Publications is considering buying a piece land at a cost of GHS87,500 for a
project and an investment of GHS12,500 in working capital. The project will have a four
year life after which the land will be disposed for GHS 3,125. The project is expected to
earn the following net cash receipts which does not include amount of GHS 18,750 which
will be incurred in the first year of operation but it will be paid in year 3
Year
1 GHS56,250
2 (GHS30,000)
3 GHS56,250
4 GHS15,625
Should the investment be undertaken using payback period and ARR?

DISCOUNTED CASH FLOW TECHNIQUE

The time value of money (discounting)
One of the basic principles of finance is that a sum of money today is worth more than the
same sum in the future. If offered a choice between receiving GHS10,000 today or in 1
years’ time a person would choose today.

A sum today can be invested to earn a return. This alone makes it worth more than the
same sum in the future. This is referred to as the time value of money.

The impact of time value can be estimated using one of two methods:

1. Compounding which estimates future cash flows that will arise as a result of investing
an amount today at a given rate of interest for a given period.

An amount invested today is multiplied by a compound factor to give the amount of cash
expected at a specified time in the future assuming a given interest rate.

2. Discounting which estimates the present day equivalent (present value which is usually
abbreviated to PV) of a future cash flow at a specified time in the future at a given rate of
interest
1 An amount expected at a specified time in the future is multiplied by a discount
factor to give the present value of that amount at a given rate of interest.

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 2 The discount factor is the inverse of a compound factor for the same period and
interest rate. Therefore, multiplying by a discount factor is the same as dividing by
a compounding factor.

3 Discounting is the reverse of compounding.

Formula: Discount factor

n
Discount factor = 1/(1 + r)
r = the interest rate per period (cost of capital) n = number of periods
Example 4: Discounting
I you expects to GHS14,055.36 receive in 4 years.

If the interest rate of 10% what is the present value of this amount?
Present value = Future cash flow × 1/ (1 + r)n

Present value = 14,055.36 × 1/(1.1)4

Present value = GHS 9,600

Example 5: Comparing cash flows.

You have to pay a loan of GHS 240,000 in 4 years’ time or pay 35,000 extra in 6 years’
time. If the interest rate on the is 9%, which offer you will you choose and why.
When you pay in 4 years time
Present value = Future cash flow × 1/ (1 + r)n
Present value = 240,000× 1/(1+0.09)4
Present value = GHS 170,022.05

When you pay in 6 years time (amount will be GHS 240,000 +35,000)
Present value = Future cash flow × 1/ (1 + r)n
Present value = 275,000× 1/(1+0.09)6
Present value = GHS 163,973.51

From the above, you have to repay the loan in 5 years’ time, since the value is lower.

Now try this!! Example 6: Comparing cash flows

You have won a lottery and the amount involve is too huge and the following offers have
been submitted to you to select one the receipts.
1. GHS 600,000 now
2. GHS 1,100,000 in 2 year’s time
3. GHS 300,000 per year for 4 years
4. GHS 50,000 per year for ever till you die
5. GHS 150,000 now and GHS 200,000 per year for 5 years
Required: which will you select and why

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Now try this!! Example 7: discounting

How much would an investor need to invest now in order to have ₦100,000 after 12
months, if the compound interest on the investment is 0.5% each month?

Adjusted or Discounted Payback Period

This considers the time value of money and therefore discounts all the cash flows.
Example 8: Adjusted Payback period
Using the data in Example 2 above with a cost of capital of 10%
Adjusted or Discounted Payback Period will be calculated as follows
year cash flow Discount factor (10%) PV of cash flows Net balance
GHS GHS GHS

o (160,000) 1 (160,000) (160,000)

1 40,000 0.909 36,360 (123,640)

2 50,000 0.826 41,300 82,340

3 90,000 0.751 67,590 (14,750)

4 60,000 0.683 40,980 0

Payback period =3 + 14,750/40,980 = 3.36 years OR

Payback period = 3yrs + (14,750/40,980)×12months = 3years and 4 months OR
Payback period = 3yrs + (14,750/40,980)×365 days = 3years and 131 days OR

Workings
Year o cashflow = GHS140,000 + GHS20,000 =GHS160,000
Year 4 cash flow = GHS5,000 + GHS35,000+ GHS20,000 = GHS60,000

Example 9: Adjusted Payback period

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Using the data in example 3 with a cost of capital of 12%
Should the project be undertaken using adjusted payback period

NET PRESENT VALUE (NPV) METHOD OF INVESTMENT APPRAISAL

The net present value (NPV) of a project is difference between the present value of all the
costs incurred and the present value of all the cash flow benefits (savings or revenues).

NPV layout
Y0 Y1 Y2 …… Yn
GHS GHS GHS GHS GHS
Sales revenue/ receipts XX XX XX XX
Variable cost/ direct costs (X) (X) (X) (X)
Incremental fixed costs( note 1) (X) (X) (X) (X)
Profit XX XX XX XX
Tax (x%) (note 2) (X) (X) (X) (X)
Tax saved on capital allowance (note 3) X X X X
Working capital (note 4) (X) (X) (X) (X) X
Scrap value - - - - X
Cost of Investment (X) - - - -
Net cash flow (X) X X X X
Discount factor (note 5) X X X X X
Present value of cash flow (X) X X X X
Net present value = Total PV of cash inflows - Total PV cost of investment

Notes!!!
1. Incremental fixed cost refers to the fixed costs which is directly related (attributable)
and incidental to the project and will be incurred if only the project is undertaken.
Look for statement like ‘incremental fixed cost or fixed cost will be incurred’.

2. Tax cash flows should be included in the year of payment not when its incurred. For
example. If tax is paid in the same year it arise, then year 1 tax will be paid in year 1
which should be included in year 1 cash flow, year 2 tax will be paid in year 2 which
should be included in year 2 cash flow and so on.

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However, if tax is paid one year in arrears, then year 1 tax will be paid in year 2 which
should be included in year 2 cash flow, year 2 tax will be paid in year 3 which should be
included in year 3 cash flow and so on.

3. Tax saved on capital allowance is calculated by multiplying the capital allowance (tax
man’s depreciation). However capital allowance is the depreciation calculated by the tax
authorities to replace the depreciation charge by the entity which must be claimed (by the
entity) to reduce the tax burdens. In investment appraisal the capital will be claimed
according to the pattern of the of tax payments, if tax is being paid in the same year then
the capital allowance too will be claimed in the same year and if tax is paid one year in
arrears then the capital allowance can also be claim one year in arrears.

4. You have to follow the three working capital assumptions or rules bellow
a) Working capital should be provide at the start of each year, meaning working
capital for year I will be provide at the start of year 1 which is year 0 (now), year 2
working capital will be provided at the start of year 2 which means year 1 and so
on.
b) Apart from the first working capital, only the changes (increase which is outflow or
decrease which is inflow) in the NPV calculation
c) The working capital at the end of the project life must be recouped or recovered or
release which is always inflow for that year. This will be explain in detail some of
the specific examples.

Relevant cash lows

The cash flows which should be include in the NPV calculation and other discounted cash
flow technique must be;
 Cash flow
Meaning only items which will result outflow (payments) or inflow (receipts) of cash
must be included. This means that all non-cash items must not be included (ignored)
e.g depreciation, provisions bad debts etc.
 In future
The relevant cash lows for evaluation must the ones to be incurred or received in the
future periods when the project is accepted. However, past and sunk costs must be
excluded e.g expenditure incurred on research and feasibility studies in other to
estimate cash flows must be ignored.
 Incremental
The cash flows must directly related or incidental to the project. And it must not
include the company’s period costs. General fixed costs and apportioned (shared)
fixed cost must be ignored.

Decision rule for the NPV

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  single Project
Accept project with positive NPV

 multiple Projects
Accept the project with the highest positive NPV.

Advantages of NPV
 NPV considers all the cash flows of the entire project life.
NPV takes into account each and every relevant cash flow from the project from the
inception of the project to end of the project. Unlike payback and discounted payback
which ignores the cash flows after the payback period.
 NPV uses cash flow but not a profit which can be influenced changes in accounting
policies. Cash flow can be difficult be manipulated by the subjective selection of
accounting policies.
 Moreover, NPV takes into consideration of risk. NPV uses the discounted cash flow
techniques by discounting all the cash flows to reflect the present value cash flows of
the project. Discount rates are used in calculating NPV; the risk of undertaking the
project (Business risk, financial risk, operating risk) gets factored into this method.
 Unlike IRR, using NPV makes sense because it does not assume that the cash flows
will be reinvested at IRR which is almost impossible. Reinvesting the cash flows at
IRR would mean you are investing back the cash flows from your project into the
market at the equivalent rate as that of your project’s rate of return. You need to find
another investment yielding same as your project for the reinvestment. Well, that’s
really difficult.
In conclusion NPV is good measure of profit, which helps to determine the amount of
return likely to be generated from the project. If you wish to choose one single project
from amongst many then NPV will be a good measure of profitability. If you use IRR for
mutually exclusive projects you might end up selecting small projects with higher IRR
and of a short-term nature at the expense of long-term (long-term value creation is good
for shareholders) and higher NPV projects.
Please note that!!!
‘All cash flows are occurred at the end of each year except otherwise stated’

Disadvantages of NPV
 It assumes that the cost of capital (discount factor) will remain the same over the
project life which may vary over the project life in reality.
 Cash flows are estimated which may be different from the actual cash flow if the
project is accepted.
 The cost of capital normally used in discounting the cashflows is based on
estimation (guesswork) which may not the same as the actual cost of capital.
 NPV ignores the sunk cost in the calculation of the cash flows which could have
significant impact on the acceptance and the actual return.

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Example 10 : NPV Target Publications

The directors of Target Publications Ltd is considering installing a new plant in one of it
press house for production of student magazine. Research and feasibility studies has been
conducted by a team of professional at of GHS 100,000 to be able to determine the cash
flows likely to arise from the projects.

The plant will cost GHS 4.5 million and expected to have 5 years useful life with a
residual value of 10% of the cost of the plant. However, the project will required a
building in addition to the plant which was acquired by the company two years ago at cost
of GHS 2.5 million with a carrying value of GHS 1.5 million and 5 years useful life
remaining. The building will be used to store the printed magazine shortly before
dispatching.
Below is details of the Project over the 5 year period
Year 1 Year 2 Year 3 Year 4 Year 5
Production and 450,000 500,000 400,000 600,000 350,000
sales units
Selling price (GHS) 15 10 12 18 20

Material cost will be GHS6.5 per unit

Other production overhead will be GHS 2.5 per game
Incremental annual fixed costs of GHS 0.35 million will be incurred in advertising to
stimulate demand. Working capital requirement for each year will be provided at 10% of
that year’s sales revenue. The magazines will be produced under one of the international
versions which requires payment of royalties the original publisher. The payments will be
as follows GHS0.2 million will be paid now, GHS1 million in year 4 and GHS0.8 million
in year 5, no royalty will be paid in the rest of the years.

Target Publications Ltd pays tax on profit at a rate of 25% per annum and tax liabilities
are settled in the year in which they arise. Target Publications Ltd uses an after-tax
discount rate of 12% when appraising new capital investments. Ignore inflation.

Required:
Calculate the net present value of the proposed investment and comment on
your findings

Net Present Value (NPV) Layout

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 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
GHS,000 GHS,000 GHS,000 GHS,000 GHS,000 GHS,000
Sales revenue (W1) 6,750 5,000 4,800 10,800 7,000
Variable cost (W2) (4,050) (4,500) (3,600) (5,400) (3,150)
Incremental fixed cost (350) (350) (350) (350) (350)
Royalties (200) - - - (1,000) (800)
Profit (200) 2,350 150 850 4,050 2,700
Tax (25%) (587.5) (37.5) (212.5) (1,012.5) (675)
Working capital (W3) (675) 175 20 (600) 380 700
Disposal (10%×4,500) 450
Cost of Investment (4,500)
Net cash flows 5,375 1,762.5 132 37.5 3,417.5 3,175
Discount factor (12%) 1 0.893 0.797 0.712 0.635 0.567
PV of net cash flow (5,375) 1,573.91 105.20 26.7 2,170.11 1,800.23

NPV = GHS 301,150

The evaluation of the investment proposal indicates that a positive net present value is
expected to be produced. The investment project is therefore financially acceptable
Workings
1. Sales
Year 1 Year 2 Year 3 Year 4 Year 5
Production and 450,000 500,000 400,000 600,000 350,000
sales units
Selling price (GHS) 15 10 12 18 20
Sales (GHS,000) 6,750 5,000 4,800 10,800 7,000

2. Variable cost
Variable cost per unit
GHS
Material cost 6.5
Other production overhead 2.5
Variable per unit 9.0

Total variable cost

Year 1 Year 2 Year 3 Year 4 Year 5
Production and 450,000 500,000 400,000 600,000 350,000
sales units
Selling price (GHS) 9.0 9.0 9.0 9.0 9.0
Sales (GHS,000) 4,050 4,500 3,600 5,400 3,150

3. Working capital

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Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Sales (GHS,000) 6,750 5,000 4,800 10,800 7,000
Working capital 675 500 480 1,080 700
Taken to NPV (675) 175 20 (600) 380 700

Please the explanatory notes to this question will be discuss class

Example 11 : Capital allowance (Straight line method) Target Publications

Target Publications acquired a piece of equipment for a profitable project at cost of GHS 4 million with
a nil scrap value and have five years useful life. The tax authorities will allow the company to claim the
capital allowance at the rate of 20% on straight line basis.

The project will produce annual contribution of GHS 2.8 million and fixed cost of GHS0.5 million will
be incurred. Tax is paid in the same year at a rate of 30% per annum. The company’s cost of capital is
10%

Required
a) Calculate the capital allowance to be claimed by Target Publications
b) Advice the company on the acceptance level of this project using net present value.

Solution
a) Capital allowance
= capital allowance (depreciation) × tax rate
= 4m × 20% × 30%
= GHS 0.24 million per year

b) Net Present Value

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
GHS,000 GHS,000 GHS,000 GHS,000 GHS,000 GHS,000
Contribution - 2,800 2,800 2,800 2,800 2,800
Fixed cost - (500) (500) (500) (500) (500)
Profit 2,300 2,300 2,300 2,300 2,300
Tax (30%) (690) (690) (690) (690) (690)
Tax saved on cap. All. 240 240 240 240 240
Cost of investment (4,000)
Net cash flow (4,000) 1,850 1,850 1,850 1,850 1,850
Discount factor (10%) 1 0.909 0.826 0.751 0.683 0.621
PV of cash flows (4,000) 1,681.65 1,528.1 1,389.35 1,263.55 1,148.85

NPV = GHS 3,012,500

Hence the project should be accepted.

Alternative 1
Calculation of net cash flows per year
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 GHS,000
Contribution 2,800
Fixed cost (500)
Profit 2,300
Tax (30% ×2300) (690)
Tax saved on cap. All. 240
Net cash flow 1,850

Net Present Value

Year Net cash lows Discount factor (10%) PV of net cash flow
GHS,000 GHS,000
0 (4,000) 1 (4,000)
1 1,850 0.909 1681.65
2 1,850 0.826 1528.1
3 1,850 0.751 1389.35
4 1,850 0.683 1263.55
5 1,850 0.621 1148.85
NPV 3,012.5

Alternative 2

Net Present Value

Year Net cash lows Discount factor (10%) PV of net cash flow
GHS,000 GHS,000
0 (4,000) 1 (4,000)
1-5 1,850 3.791 7,013.35
NPV 3,013.35

1  

n

Annuity factor =  (1 i )  , where 𝒊 = 𝟎. 𝟏 𝒂𝒏𝒅 𝒏 = 𝟓𝒚𝒓𝒔 (kindly

 i 
 
substitute)

= 𝟑. 𝟕𝟗𝟏

Example 12 : Capital allowance (Reducing balance method) Target

Publications

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 19
Target Publications is considering installing a new assemble plant for a new project at cost of GHS 1
million with a scrap value of GHS0.1 million which will last for the entire project life of four years. The
tax authorities will the company to claim a tax allowable depreciation over the life of the plant at a rate
of 25% per annum on reducing balance method.

The project will produce annual profit of GHS0.10 million after depreciation but before tax. It is the
policy of the company to depreciate its non-current assets on straight line basis. Tax is paid one year in
arrears at annual rate of 27%. The after tax cost of capital is 20%.

Required
c) Calculate the capital allowance to be claimed by Target Publications
d) Advice the company on the acceptance level of this project using net present value.

Solution
a) Capital allowance
= capital allowance (depreciation) × tax rate
Year Capital allowance Balance left (optional) Tax saved Timing
GHS,000 GHS,000
1 (1,000 ×25%) = 250 (1,000-250)=750 (250 ×27%)=67.5 Year 2
2 (750 × 25%) = 187.5 (750-187.5)= 562.5 (187.5×27%)=50.63 Year 3
3 (562.5 ×25)= 140.63 (562.5-140.63) =421.87 (140.63 ×27%)=35.16 Year 4
4 (421.87-100)= 321.87 - (421.87×27%)=113.9 Year 5

Calculation of cash flows for years

GHS,000
Profit 150
Add back depreciation
(1,000-100)/4 225
cashflow 375
Tax
Tax (27% ×375) (101.25)

Net Present Value

Year cash lows Tax (27%) Tax saved on Scrap Net Discount PV of net
Capit. allowance value casflows factor (12%) cash flow
Ȼ,000 Ȼ,000 Ȼ,000 Ȼ,000 Ȼ,000 Ȼ,000
0 (1,000) - - (1,000) 1 (1,000)
1 375 - - 375 0.833 312.38
2 375 (101.25) 67.5 341.25 0.694 236.83
3 375 (101.25) 50.63 324.38 0.579 187.82
4 375 (101.25) 35.16 100 408.91 0.482 197.09
5 - (101.25) 113.9 12.65 0.402 5.09
NPV (60.80)
The investment should be rejected since the net present value is negative

INTERNAL RATE RETURN (IRR) METHOD OF INVESTMENT APPRAISAL

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Internal rate of return is the discount rate (cost of capital) at which the NPV of a project is equal to zero.
This also known as breakeven rate or sensitivity analysis on cost of capital. However, this is a guesswork
by guessing two different discount factors and calculate the NPV at each rate and use it to calculate the
IRR
IRR is the highest cost of capital that the entity will be willing to accept and any rate above that will
result a negative NPV and hence will be rejected.

Steps in calculating IRR

1. Guess the first rate (e.g rate ‘a’) and calculate the NPV at that rate

2. Guess another rate( which always depends on the first NPV) and
calculate the NPV at that rate
i. If the first NPV is positive, choose a higher rate that will bring the
second NPV to negative (it will still work even if the second NPV is
not negative once a higher rate is selected)

ii. If the first NPV is negative, choose a lower rate that will bring the
second NPV to positive (it will still work even if the second NPV is
not positive once lower rate is selected)

3. Now calculate the IRR using the formula bellow

𝑷𝑵𝑽(𝒂)
IRR= 𝒂 + × (𝒃 − 𝒂),
𝑵𝑷𝑽(𝒂)−𝑵𝑷𝑽(𝒃)

Where, 𝒂 = 𝒇𝒊𝒓𝒔𝒕 𝒓𝒂𝒕𝒆,

𝑵𝑷𝑽(𝒂) = 𝒇𝒊𝒓𝒔𝒕 𝑵𝑷𝑽

𝒃 = 𝒔𝒆𝒄𝒐𝒖𝒏𝒅 𝒓𝒂𝒕𝒆

𝑵𝑷𝑽(𝒃) = 𝒔𝒆𝒄𝒐𝒖𝒏𝒅 𝑵𝑷𝑽

Decision rule for the IRR

 single Project
Accept project with IRR greater than the company’s cost of capital

 multiple Projects
Accept the project with the highest IRR.

Example 13 : Internal rate of return Target Professional Konsults

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 21

Target Professional Konsults is considering an investment which requires initial outlay of

GHS240,000 to acquire machinery and development cost of GHS50,000 which will be
incurred now and paid for at the start for year 3.
The project will last for a period of five years with an annual net cash flow of GHS22,500
the first two years, GHS25,200 the next years and GHS35,900 in year five. Annual
depreciation of the machinery has been deducted before arriving at these cash flows. The
cost of capital for the company is 12%

Required
a) Calculate the IRR of the investment
b) Advice the company on the acceptance level of this project using your answer
above.

Solution
 Step 1 Let rate ‘a’ be equal to 10%
Therefore NPV(a) will be as follows
Year cash flows Cost of Inv./ Depreciation Net Discount PV of net
Dev.cos cashflow factor cash flow
(10%)
GHS GHS GHS GHS GHS
0 (240,000) (240,000) 1 (240,000)
1 22,500 48,000 70,500 0.909 64,084.50
2 22,500 (50,000) 48,000 20,500 0.826 16,933.00
3 25,200 48,000 73,200 0.751 54,973.20
4 25,200 48,000 73,200 0.683 49,995.60
5 35,900 48,000 83,900 0.621 52101.90
NPV -1,911.80

Depreciation = 240,000/5yrs
=GHS 48,000

 Step 2 Let rate ‘b’ be equal to 8% ( since the NPVa is negative)

Therefore NPV(b) will be as follows
Year Net cashflow Discount PV of net
factor cash flow
(8%)
GHS GHS
0 (240,000) 1 (240,000)
1 70,500 0.925 65,212.5
2 20,500 0.857 17,568.5
3 73,200 0.794 58,120.8
4 73,200 0.735 53,802.0
5 83,900 0.681 57,135.9
NPV (11,839.7)

 Step 3 finally IRR is calculated as follows

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 𝑷𝑵𝑽(𝒂)
IRR= 𝒂 + × (𝒃 − 𝒂),
𝑵𝑷𝑽(𝒂)−𝑵𝑷𝑽(𝒃)

Where, 𝒂 = 𝟏𝟎,

𝑵𝑷𝑽(𝒂) = −𝟏, 𝟗𝟏𝟏. 𝟖𝟎

𝒃=𝟖

𝑵𝑷𝑽(𝒃) = 𝟏𝟏, 𝟖𝟑𝟗. 𝟕𝟎

−𝟏,𝟗𝟏𝟏.𝟖
IRR= 𝟏𝟎 + × (𝟖 − 𝟏𝟎)
−𝟏,𝟗𝟏𝟏.𝟗𝟎−𝟏𝟏,𝟖𝟑𝟗.𝟕

𝑰𝑹𝑹 = 𝟗. 𝟕𝟐%
b) The project should be rejected since the IRR is lower the company’s cost of
capital.

Example 14 : Internal rate of return Target Professional Konsults

For each of the example 10, 11 and 12
Required
a) Calculate the IRR of the investment
b) Advice the company on the acceptance level of this project using your answer
above.
c) What are the other factors to be considered?

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SOLVED QUESTIONS (Kindly check the end of Q3 for the solutions)

Question 1 New Ventures CIBG April 2019

New ventures Ltd is considering investing in one of two projects. Nyansa Bank Ltd has been
approached to provide a bank facility to support the projects. The bank is willing to only one
of the projects. The information below relates to the two potential projects:

Project Y Project Z
GH¢,000 GH¢,000
Initial capital outlay 260,000 320,000
Net Cash inflows
1 150,00 100,000
2 200,00 110,000
3 50,000 120,000
4 30,000 160,000
5 20,000 190,000

Additional information available indicates the following:

1. The initial capital outflow in respect project Y include GH¢ 60 million for land acquisition. The
land owner have agreed that the amount is to be paid in equal installments at the end of year 2
and 3. This fact has been not in the cash flows above.

2. A piece of plant expect to be paid for at the end of year 1 at accost of GH¢ 40 million in respect
of project Z has not been included in the figures given above, however depreciation of the plant
has been deducted before arriving at the forecast cash flows for year 2 to 5 in respect of project
Z. the plant has a useful life of 4 years with no residual value.

3. The company’s cost of capital of is 20% per annum over the five year period and be the initial
outlay is assumed to be incurred immediately subject to any necessary adjustments any other
payments or receipts are also assumed to occur at the end of each respective year
Required
a) Assess the two projects using the payback period and Net Present Value method of project
appraisal
b) Based on your results, comment on two advantages of each in respect of the two methods.
c) With reference to the above projects, state the acceptance criteria for the two approaches.

Question 2
a) Explain why Net Present Value is considered technically superior to Payback and Accounting
Rate of Return as an investment appraisal technique even though the latter are said to be easier
to understand by management. Highlight the strengths of the Net Present Value method and the
weaknesses of the other two methods. (6 marks)

b) Your customer has the option to invest in projects T and R but finance is only available to one
of them.
You are given the following projected data:

Project T Project R
GH¢ GH¢
Initial cost 70,000 60,000
Profits:
1 15,000 20,000
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 2 18,000 25,000
3 20,000 (50,000)
4 32,000 10,000
5 16,000 3,000
6 2,000
You are told:
All cash flows take place at the end of the year apart from the original investment in the project which takes place
at the beginning of the project.

1) Project T machinery is to be disposed of at the end of year 5 with a scrap value of GH¢10 000.
2) Project R machinery is to be disposed of at the end of year 3 with a nil scrap value and
replaced with new project machinery that will cost GH¢75 000.

3) The cost of this additional machinery has been deducted in arriving at the profit
projections for R for year 3. It is projected that it will last for three years and have a
nil scrap value.

4) The company’s policy is to depreciate its assets on a straight line basis.

5) The discount rate to be used by the company

is 14%. Required:
a) Calculate for projects T and R taking into consideration your decision in notes above:
i) Payback period
ii) Net present value and advise which project should be invested in, stating your reasons

Question 3 Agape Intervention Oct. 2019 (Target)

The Directors Agape Ltd is considering investing in one of two projects. BBB Bank Ltd has been
approached to provide a bank facility to support the projects. The bank is willing to only one of the projects.
The information below relates to the two potential projects:

Project G Project H
Initial capital outlay GH¢ 520,000 GH¢ 1,000,000

Year Revenue Operating cost Revenue Operating cost

GH¢ GH¢ GH¢ GH¢
1 300,000 150,000 1,200,000 780,000
2 800,000 200,000 800,000 500,000
3 150,000 200,000 500,000 700,000
4 350,000 400,000 200,000 560,000
5 80,000 60,0000 900,000 600,000

Additional information available indicates the following:

Information about Project G
The initial capital outlay include GH¢10,000 paid for research and feasibility studies
conducted before arriving at the forecasted cash flows.
Project G machinery is to be disposed of at the end of year 5 with a scrap value of GH¢10,
000.

Information about Project H

The initial outlay include GH¢100, 000 represent and additional development cost which will be
paid for in year 3 Project H machinery is to be disposed of at the end of year 5 with a nil scrap
value
General information
1) All cash flows take place at the end of the year apart from the original investment in the
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 25
project which takes place at the beginning of the project.

2. The company’s policy is to depreciate its assets on a straight line basis. Depreciation has
included in the operating costs for both projects

3. The cost of capital to be used by the company is 10%.

Required
a) Assess the two projects using the Net Present Value method of project appraisal (18 marks
b) Explain the limitations of Net Present Value as method of investment appraisal. (2 marks)

Solution 1.
a) New==
ventures
Net Present Value (NPV) Project Y
Year Cashflows Adjustments Net cashflows Discount Present
factor (20%) value
GH¢,000 GH¢,000 GH¢,000 GH¢,000
0 260,000 (60,000) (200,000) 1 (200,000)
1 150,00 - 150,000 0.833 124,950
2 200,00 (30,000) 170,000 0.694 117,980
3 50,000 (30,000) 20,000 0.579 11,580
4 30,000 - 30,000 0.482 14,460
5 20,000 - 20,000 0.402 8,040
NPV 77,010

Notes
1. GH¢ 60 million will be subtracted from initial cost outlay ( because it will not be in year
0 (now) but year 2 and 3)
2. And will be divided equally which will be subtracted from the year 2 and 3 cash flows
(because its an outflow or payment)

Net Present Value (NPV) Project Z

Year Cashflows Adjustments Net cashflows Discount Present
factor (20%) value
GH¢,000 GH¢,000 GH¢,000 GH¢,000
320,000 - (320,000) 1 (320,000)
1 100,000 (40,000) 60,000 0.833 49,980
2 110,000 + 10,000 120,000 0.694 83,280
3 120,000 + 10,000 130,000 0.579 75,270
4 160,000 + 10,000 170,000 0.482 81,940
5 190,000 + 10,000 200,000 0.402 80,400
NPV 50,870
Workings
1. Depreciation = 40,000/4yrs = GH¢10,000 (add back)
Notes
1. GH¢ 40 million will be subtracted from cash flow in year 1 ( because it has not been
included (omitted ) subtract because it’s an outflow or payment)
2. Depreciation of GH¢10 million will be added back (reversal) because it was deducted.

Payback Period ( Project Y)

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 Year Net cash flows Balance
GH¢,00 GH¢,000
0 0(200,000 (200,000)
1 ) 150,00 (50,000)
2 0
170,00 -
3 020,00
4 0
30,000
5 20,000
𝟓𝟎,𝟎𝟎𝟎
Payback period = 𝟏 + = 𝟏. 𝟕𝟏𝒚𝒆𝒂𝒓𝒔
𝟏𝟕𝟎,𝟎𝟎𝟎

Payback Period ( Project Z)

Year Net cashflows Balance
GH¢,000 GH¢,000
0 (320,000) (320,000)
1 60,000 (260,000)
2 120,000 (140,000)
3 130,000 (10,000)
4 170,000 0
5 200,000
𝟏𝟎,𝟎𝟎𝟎
Payback period = 𝟑 + = 𝟑. 𝟏𝟒𝒚𝒆𝒂𝒓𝒔
𝟕𝟎,𝟎𝟎𝟎

b) Advantages of NPV

i) It considers cash flows for all period

ii) It takes into consideration the time value of money by discounting the cash flows.
iii) It is based on objective cash flows, not profits which can be manipulated by a
subjective accounting policy
iv) It shows the change in shareholders’ wealth arising from an investment decision

Advantages of Payback Period

i) The payback is easy to calculate and understand
ii) It is based on objective cash flows, not profits which can be manipulated by a
subjective accounting policy
iii) It can be used to eliminate project that will take too long to pay back

c) Acceptance criteria for NPV

For a single project accept a project with a positive NPV, but with multiple Project accept the one with
the highest positive NPV
For the above projects, Project Y should be accepted (because it have the highest NPV)

Acceptance criteria for Payback Period

For a single project accept a project that can pay back, but with multiple Project accept the one with
the least payback period.
For the above projects, Project Y should be accepted (because it the least payback period.)

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Question 2
a) Strengths of NPV
v) It considers cash flows for all period
vi) It takes into consideration the time value of money by discounting the cash flows.
vii) It is based on objective cash flows, not profits which can be manipulated by a
subjective accounting policy
viii) It shows the change in shareholders’ wealth arising from an investment decision

Limitations of the other two methods (payback and accounting rate of return)
Payback period.
i) It ignores all cash flows after the payback period, and so ignores the total cash returns from
the project. This is a significant weakness with the
payback method.
ii) It ignores the timing of the cash flows during the payback period

Accounting rate of return

i) It is based on accounting profits, and not cash flows.

ii) Accounting profits are an unreliable measure. It can be affected by the changes in
accounting policy

iii) The ARR method ignores the timing of the accounting profits.

iv) The ARR is a percentage return, relating the average profit to the size of
the investment. It does not give us an absolute return.

Net Present Value (NPV) Project T

Year Profit Adjustments Net cashflows Discount Present
factor (14%) value
GH¢ GH¢ GH¢,000 GH¢
0 (70,000) - (70,000) 1 (70,000)
1 15,000 + 12,000 27,000 0.877 23,679
2 18,000 + 12,000 30,000 0.769 23,070
3 20,000 + 12,000 32,000 0.675 21,600
4 32,000 + 12,000 44,000 0.592 26,048
5 16,000 22,000 38,000 0.519 19,722
NPV 44,119

Workings
𝒄𝒐𝒔𝒕−𝒓𝒆𝒔𝒊𝒅𝒖𝒂𝒍 𝒗𝒂𝒍𝒖𝒆 𝟕𝟎,𝟎𝟎𝟎−𝟏𝟎,𝟎𝟎𝟎
1. Depreciation = 𝟏𝟐, 𝟎𝟎𝟎
= 𝒆𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒅 𝒖𝒔𝒆𝒇𝒖𝒍 𝒍𝒊𝒇𝒆 = 𝟓 𝒚𝒓𝒔

2. The year 5 adjustment represent the sum of depreciation and scrap value (12,000
+10,000) 22,000
3. Scrap value is an inflow so we add it to year 5 cash flow.

27
 Net Present Value (NPV) Project R
Year Profit Adjustments Net cashflows Discount Present
factor (14%) value
GH¢ GH¢ GH¢,000 GH¢
0 (60,000) (60,000) 1 (60,000)
1 20,000 + 20,000 40,000 0.877 35,080
2 25,000 + 20,000 45,000 0.769 34,605
3 (50,000) + 20,000 (30,000) 0.675 (20,250)
4 10,000 + 25,000 35,000 0.592 20,720
5 3,000 + 25,000 28,000 0.519 14,532
6 2,000 + 25,000 27,000 0.456 12,312
NPV 36,999

Workings
1. Depreciation on the existing machine for 3 years which will be on the original cost (from year
1 to 3)

𝒄𝒐𝒔𝒕 𝟔𝟎,𝟎𝟎𝟎 = 𝟐𝟎, 𝟎𝟎𝟎

Depreciation =
𝒆𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒅 𝒖𝒔𝒆𝒇𝒖𝒍 𝒍𝒊𝒇𝒆 𝟑 𝒚𝒓𝒔

Depreciation on the additional machine for 3years which will be on the new cost only (from year 4 to 6)

Depreciation = 𝒄𝒐𝒔𝒕 𝟕𝟓,𝟎𝟎𝟎

𝒆𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒅 𝒖𝒔𝒆𝒇𝒖𝒍 𝒍𝒊𝒇𝒆 𝟑 𝒚𝒓𝒔
𝟐𝟓,𝟎𝟎𝟎

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Question 3 Agape Ltd
a) NPV of project G
Year Revenue Operating Scrap Net Discount Present
cost W2 value cashflows factor (14%) value
GH¢ GH¢ GH¢ GH¢
0 (510,000) 1 (510,000)
1 300,000 (50,000 - 250,000 0.909 227,250
2 800,000 (200,000) - 600,000 0.826 495,600
3 150,000 (100,000) - 50,000 0.751 37,550
4 350,000 (300,000) - 50,000 0.683 34,150
5 80,000 (110,000) 10,000 (20,000) 0.621 (12,420)
NPV 272,130

Workings
1. Initial cost outlay
GH¢
Initial cost 520,000
Less research cost (10,000)
510,000
Research cost are not supposed to
be added (it has been added so
we have to subtract)

2. Operating cost

0 1 2 3 4 5
GH¢ GH¢ GH¢ GH¢ GH¢ GH¢
Operating cost 150,000 300,000 200,000 400,000 210,000
Depreciation - (100,000) (100,000) (100,000) (100,000) (110,000)
- 50,000 200,000 100,000 300,000 140,000

𝒄𝒐𝒔𝒕−𝒓𝒆𝒔𝒊𝒅𝒖𝒂𝒍 𝒗𝒂𝒍𝒖𝒆 𝟓𝟏𝟎,𝟎𝟎𝟎−𝟏𝟎,𝟎𝟎𝟎

3. Depreciation =
𝒆𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒅 𝒖𝒔𝒆𝒇𝒖𝒍 𝒍𝒊𝒇𝒆 𝟓 𝒚𝒓𝒔
= 𝟏𝟎𝟎, 𝟎𝟎𝟎

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 Note that depreciation has added to the operating cost so we will subtract it.

Alternative presentation.
Year 0 1 2 3 4 5
GH¢ GH¢ GH¢ GH¢ GH¢ GH¢
Initial cost (510,000) - - - - -
W1
Revenue - 300,000 800,000 150,000 350,000 80,000
Operating (50,000) (200,000) (100,000) (300,000) (110,000)
cost W2
Scrap value - - - - - 10,000
Net cash (510,000) 250,000 600,000 50,000 50,000 (20,000)
flow
Discount 1 0.909 0.826 0.751 0.683 0.621
factor(10%)
Present
value (510,000) 227250 495600 37550 34150 (12420)

NPV 272,130

b) NPV of project H
Year Revenue Operating Dev. Net Discount Present
cost W2 cost cashflows factor value
(14%)
GH¢ GH¢ GH¢ GH¢
0 - (900,000 1 -900,000
1 1,200,000 (600,000 - 600,000 0.909 545,400
2 800,000 (320,000) - 480,000 0.826 396,480
3 500,000 (320,000) (100,000) 80,000 0.751 60,080
4 200,000 (320,000) - (120,000) 0.683 -81,960
5 900,000 (420,000) 380,000 0.621 235,980
255,980

Workings
4. Initial cost outlay
GH¢
Initial cost 1,000,000
Less additional development cost (100,000)
900,000
additional development cost will
be incurred in year 3

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5. Operating cost

0 1 2 3 4 5
GH¢ GH¢ GH¢ GH¢ GH¢ GH¢
Operating cost 780,000 500,000 500,000 500,000 560,000
Depreciation - (180,000) (180,000) (180,000) (180,000) (180,000)
- 600,000 320,000 320,000 320,000 380,000

𝒄𝒐𝒔𝒕
6. Depreciation 𝟗𝟎𝟎,𝟎𝟎𝟎𝟎 = 𝟏𝟖𝟎, 𝟎𝟎𝟎
𝒆𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒅 𝒖𝒔𝒆𝒇𝒖𝒍 𝒍𝒊𝒇𝒆 = 𝟓 𝒚𝒓𝒔

Note that depreciation has added to the operating cost so we will subtract it.

b) limitations of NPV
i. It requires the forecasting of cash flows into the future which is subject to
uncertainties
ii. NPV ignores the time it takes for a project to recoup the amount invested
iii. NPV is not appropriate for capital rationing decisions
iv. The selection of an appropriate discount factor for discounting net cash flows can be a
challenge

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 TUTORIAL QUESTIONS
Question 1 Agyasco ICAG NOV 2017 Q1
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 150,00 70,00 60,00 60,00
Selling price (GH¢ 0
25 0
24 0
23 0
22
per
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.

Question 2 Esinam (adopted) ICAG NOV 2018 Q1

Esinam 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
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year after the end of the project.

The research and development division has prepared the following demand forecast:
Year 1 2 3 4
Demand 110,000 130,00 150,000 145,0
(units) 0 0
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 GH¢

Materials cost 12.00
Direct labour 5.00
Variable overhead 2.50
Fixed overhead (allocated) 3.50
Distribution (Variable) 5.50

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 8% per annum after tax. (Ignore Capital Allowance).

Required:
Assess the financial desirability of this venture, computing the net present value offered by
the project.

Question 3 Kwame ICAG MAY 2017 Q1

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.
Question 4 Abrefa CIBG Oct 2017 Q2
Abrefa has just set up Success Ltd. which is seeking profitable ventures to invest the capital
Abrefa had accumulated during the several years of his work as a public servant through
savings. The company has engaged you as a Management Accountant. Information gathered
through a survey indicates that if the company introduces its new line ‘yoryi’ the following
is likely to result:
i. Sales of 15,000 units could be achieved if the price were set at GH¢200.
ii. Variable cost will be GH¢175 per unit.
iii. Fixed costs would amount to GH¢75,000 per annum.
iv. The life of the project is expected to be 5 years.
v. The cost of capital is 10%.
vi. An additional GH¢300,000 will have to be spent on development before production
can commence. The amount of development cost includes of GH¢200,000
representing the time spent on Research & Development personnel. If these personnel
were not working on this project, they would devote their time to ‘pure research’.
vii. Special plant will have to be purchased for GH¢100,000 immediately. This should be
depreciated at the rate of 25%. The depreciation of special plant is included in the fixed
costs.
Required
a) As the newly engaged Management Accountant, you are required to report to the
Board of Success Ltd. indicating whether or not the project is worthwhile using the
NPV and IRR methods of project appraisal.
b) List three strengths and three weaknesses of the NPV method of project appraisal

Question 5 Yehowa –Da Company

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.

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b) Advise Yehowa –Da Company Ltd on whether or not to proceed with the
investment in the ice cream plant.

Question 6 Darn Co
Darn Co has undertaken market research at a cost of $200,000 in order to forecast the future
cash flows of an investment project with an expected life of four years, as follows:

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

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 after-tax cost of capital of 7% per year.

Required:

Calculate the net present value of the investment project and comment on its financial
acceptability.
Question 7 Pagsana Company

a) Pagsana Company plans to introduce a new product line for production of its local drink in
Walewale. The company therefore, decided to acquire either semi-automated plant or an
automated plant. The relevant data for the two proposed plants are as follows:
AUTOMATED SEMI-AUTOMATED
GH¢ GH¢
Original purchase price 2,000,000 1,000,000
Installation cost 500,000 200,000
Yearly Sales revenue 2,000,000 2,000,000
Yearly material and labour cost 900,000 1,400,000
Yearly variable overhead 600,000 300,000
Yearly apportioned fixed overhead 200,000 100,000

Estimated useful life 15 years 14 years

Method of depreciation Straight line Straight line
Cost of Capital 10% 10%

Required:
i) Select the appropriate plant on the basis of:
• Payback Period (4 marks)
• Net Present Value (7 marks)

ii) Explain TWO (2) advantages of discounted cash flow method of investment appraisal.
(4 marks)

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