The Time value of money: Capital investments usually earn returns that extend over fairly long periods of time, Therefore, it is important to recognise the time value of money when evaluating investment proposals. A rupee today is worth more than a rupee a year from now if for no other reason, than that you could put a rupee in bank today and have more than rupee a year from now, Therefore, projects that promise earlier returns are preferable to those that promised later returns. Capital budgeting techniques that recognize the time value of money involve discounting cash flow. The Net Present Value (NPV) Method: /V (1, [he . Discounted Cash Flow Techniques: The discounting of the projected net cash: flows of a capital projected to ascertain its present value. The methods commonly used are: _ «Net Present Value (NPV) in which the discount rate is chosen and the present value is expressed as a sum of money. + Internal Rate of Return (/RR) in which the calculation determines the return in the form of a percentage. * Discounted Payback, in which the discount rate is chosen, and the Payback is the number of years required to repay the original investment. Present Valu &: “The cash equivalent row of a sum of money receivable or payable at a future date.” The timing of cash flows is taken into account by discounting them. The effect of discounting is to give a bigger value per Rs.1 for cash flows that occur earlier .i.e. Rs.1 eamed after one year will be worth more than Rs.1 eamed after two years, which in tum wili be worth more than Rs.1 earned after five year and soon. Our objectives is to calculated and compare.returns on an investment in a capital project with an alternatives equal risk investment in securities traded in the financial markets. This comparison is made using a technique called discounting cash flow (DCF) eraivale Because a DCF analysis is the opposite of the concept of compounding interest. : Scanned with CamScannernt Value (NPV. 's cash flows is compared to the present value f of Net P! ‘ect of a _proy The present Va Ws. the difference between the present values of these cash’, eid ihe Net Present Value, determines whether or not the project is an accepts le investment. V) is the difference between the sum of the projected discounteg (NP' i Nek Presstt bia ih attributable to a capital investment or other long-term Project, — caphe evesinen cash inflows and ares the present value of all cash inflows from a projected with the Present outflows from a project. The NPV is thus calculated as the Present ent value of cash outflows. ee {? Lee G0N £6 ke» Leg 1. Positive / greater than zero Accepted / undertaken because it promises a return greater than the required rate of retum. The NPV comp value of all the cash ou value of cash inflows minus the pres Vic Cee = 2. ‘Negative / lower than zero Not be accepted / undertaken because it promises a return less than the required rate Nefody of return. 3. Exadtly zero It means that the present value of the cash inflows and outflows are equal and the project SG = Leach 220 will be only just worth undertaking. If comparisot’ between two or more mutually exclusive projects, the project with the highest positive NPV should be selected. The net present value is based on cash flows of a project, not accounting profits. Assumptions in the NPV Model: NEL Loxyens V Vokue - = Forecasts are certain = — Information is freely available and costless. The discount rate is a measure of the opportunity cost of funds which ensures wealth maximization for all individuals and companies. Scanned with CamScannerNet Terminal Value (NTV): Ni NTV is the cash surplus remaining at the end of a project after taking account of interest and capital repayments. The NTV discounted at the cost of capital will give the NPV of the project. Example # 05: A project has the following cash flows: Years 0 1 2 3 4 Cash Flow (Rs.) (80,000) 30,000 26,000 _ 32,000 __ 30,000 Company's cost of capital is 10%. Required: Calculate the Net Terminal Value (NTV) of the project. Solution: Rs. Initial outflow (80,000) Interest in years 1 at 10% (8,000 ) (88,000) Repayment at the end of year 1 30,000 Balance outstanding at end of year 1 8,000) Interest in years 2 at 10% (5,800 ) (63,800) Scanned with CamScannerSESE ne Repayment at the end of year 2 26,000 Balance outstanding at end of year 2 (37,800) Interest in years 3 at 10% (3,780 ) (41,580) Repayment at the end of year 3 32,000 Balance outstanding at end of year 3 (9,580) Interest in years 4 at 10% (958 ) (10,538) Repayment at the end of year 4 30,000 Cash surplus at the end of project 19,462 The net Terminal Value is Rs. 19,462. Internal Rate of Return (IRR): The Internal Rate Return (IRR) is an alternative technique for use in making capital investment decisions that also takes into account the time value of money. The internal rate of return represents the true interest rate earned on an investment over the course of its economic life. This measure is sometimes referred to as the discounted rate of return. The ‘Internal Rate ‘of Return (IRR) is ‘the annual percentage return achieved by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of thé discounted'cash outflows. Simply IRR means a rate of interest at which the NPV of an investment is Zero. The IRR can be found’ by trial and error by using a number of distinct factors until the NPV equal Zero. For example if we use factor 15% discount factor and get positive NPV. We must therefore try a higher figure. Applying 25% gives a negative NPV. We know then that the NPV will be zero somewhere between 15% and 25%. If the IRR is greater than the target rate of return'/ opportunity cost of capital, the investment is profitable:and will yield a'positive NPV. © - If IRRis less than the target rate of return’/ opportunity cost of capital, the investment is unprofitable and will result a negative NPV. Formula for calculating the IRR: The IRR under trial and error Method: Where; A= Lower rate of discount X (B-A) B =Higher rate of discount a = NPV of lower rate of discount b=NPV of higher tate of discount IRR=A+ Scanned with CamScanner“Steps to calculate IRR: 9 lf the resuttin 19 NPV> 0, recalculate the NPV using a higher rate, the * The closer these NPVs are to zero, t Withe resulting NPV < 0, recalculate closer the estimate to the true IRR. the NPV using a lower rate. Put figures in the Formula, 8 of IRR method: : ~ » The main advantage is that the information it provides is more easily underetece ey managers, especially non-financial managers. The project will be expected to initial capital outflow. > A discount rate does not have to be specified before the IRR can be calculated, a hurdle rate is simply required to which the IRR can be compared, ») Disadvantages of IRR method: Tenia > \imanagers were given information about both ROCE (OR ROI) and IRR, it might be easy to get their relative meaning and significance mixed up. > [tignores the relative size of investments. > When discount rates are expected to differ over the life of the project, such variations -can be incorporated easily into NPV but not into IRR calculations. >There are problems with using the IRR when the project has non-conventional cash flows or when deciding between mutually exclusive projects. Scanned with CamScannerNPV versus IRR: Which is better? = When ‘cash flow patterns conventi 56} s attems are convent Y methods give the same accept or reject decision. Pan ¥ = The IRR method is more easily understood ” » IRRand ROCE/ROI can be confused, v = IRR ignores the relative sizes of investments. = When cash flow patterns are non-c i conventional there may be several IRRs of which decision makes must be aware to avoid making the wrong decision. = The NPV method is superior for ranking mutually v exclusive projects in order of attractiveness. When discount rates are expected to differ over the life of the project, such variations can be incorporated easily into NPV calculations but not into IRR calculation. Despite the advantages of the NPV method over the IRR method, the IRR method is widely used in practice. Modified Internal Rate of Return (MIRR): The MIRR overcomes the problem of the reinvestment assumption and the fact that changes in the cost of capital over the life of the project cannot be incorporated in the IRR method. Advantages of MIRR: | > The MIRR has the advantage of IRR that it assumes that the reinvestment rate is the IRR itself, which is usually untrue. > In many ‘cases where there is conflict between the NPV and IRR methods, the MIRR will give the same indication as NPV, which is the correct theoretical dd. This helps when explaining the appraisal of project to managers, who aera the concent of rate of return easier to understand than that of NPV. Disadvantages of MIRR method: : > AMIRA like all rate of retum methods, suffers from the problem that it may lead an investor to reject a project which has a lower rate of return but because of its size, generates a larger increase in wealth. > In the same way, 2 high return project with a short life may be preferred over a lower return project with a longer life. Scanned with CamScanneree Example s ; rt requiring an initial investment of Rs.24,500 with cash inflows of Rs.15 ™~ ar 1.and 2 and.cash inflows of Rs.3,000 in year 3" and 4" year. The Cost of geo in ital is 10%. Discount Present Present Discount [Year Cash flow Factor Value Factor 10% Rs. ; (24,500) (1.4) = 1.00 (24,500) (1.25)° = 1.00 i 15,000 | (1.1) =0.909 13,635 |_| (1.25)" = 0.800 12,000 .640 9,600 (1.25 (1.1)? = 0.826 12,390 (1.1)? = 0.751 2,253 (1.25)" 512 0.683 2,049 (1.25)4= 0.410 NPV 5,827. NPV (134) 15,000 3,000 3,000 HON " IRR=A+| op ¥ (B-A) ; 5,827 IRR = 10% +| sac * (25% ~ 10% ) IRR = 24.7 % MIRR is calculated on the basis of reinvesting the inflows at the cost of capital. Year Cash Interest Rate re eicea Inflows Multiplier Re 5 4 15,000 19,965 2 15,000 18,150 3 3,000 3,300 4 3,000 3,000 44,415 low in year 0 (Rs. 24,500) is compared with the possible inflow at s the factor in year 4 The total cash outfi this gives 2 1 4, and the resulting figure of Rs. 24,500 + 44,415 = 0.552 is yea By looking along the year 4 row in present value tables you will see that return of 16%. This means that the Rs. 44,415 received in year 4 is equivalent to Rs. 24,500 today i.e. year 0, if the discount rate is 16%. Alternatively; instead of using discount tables, we can calculate the MIRR as follows: ~ 44,415 Total Return = —3qSog— = 1.813 ; MIRR = ‘*V4.813 -1 ‘ MIRR = 1.16 - 1 MIRR = 16% “in theory the MIRR of 16% will be better measure than the IRR of 24.7%. Scanned with CamScannerINCORPORATING WORKING CAPITAL IMPACT ON : IMPACT ON ; AFTER TAX INTEREST RATES OPERATING FLOWS. DISCOUNT RATES APPROACH TO NPV- CAPITAL QUESTIONS ALLOWANCES REAL METHOD NOMINAL (MONEY) 1 The relationship between inflation rates and interest rates Inflation is a general increase in prices leading to a general decline in the real value of money. In times of inflation, the fund providers will require a return made up of two elements: + real return for the use of their funds (i.e. the return they would want if there were no inflation in the economy) = additional return to compensate for inflation. The overall required return is called the money or nominal rate of return. Mlustration 1 — Relationship een inflation and interest rates _ An investor is prepared to invest $100 for one year. He requires a real return of 10% pa. In addition, he requires compensation for loss of purchasing power igea | resulting from inflation which is currently running at 5% pa. Scanned with CamScanner@/4/ 7) — Ingestion Famula= (I++ impending.) vn EA y= lt 1a \) What money rate ot AEA it Solution le require’ “Va i fed Just to compensate for inflation, his money needs to increase by 5%, to $100 x 1.05 = $105. To give a real return on top of this, it must further increase by 10%, to $105 x 1.1 = $115.50. Thus his money must increase overall by 1.05 x 1.1 = 1.155, i.e. by 15.5%. So the investor's actual required return is 15.5%. baa = fod © MONEY RATE 15.5% a f (NOTE: 1.55 = 105 + J0 X 1.10) ingvezse © / \ j } yas (Ox) Foto ——. fos vr ) ' INFLATION - Nh REAL RATE ALLOWANCE, dre lax GU, me " yoo eC STB) | The real and money (nominal) returns are linked by the formulae: | t (+m)=(1 +r (144) t or — (1+m) \ ee cy ; Note: the ACCA formula sheets gives this as (1 +i) = (1+ n)(1 + h) where i = money rate r =real rate h = inflation Scanned with CamScanneri ee current sake 10D 200) oe ‘ , 3 ' N 1 \o inylatien (Cont (org) Ce “Tau @/1a re tn ry q 1)! > q i) > aay ini aedl nese 10, HY Scanned with CamScannerW D Vv Hews fo Pad Oe aay a ee re, ee Assets Ub= read ion Tax soenedy m | \ 00, 000 20000 ies i 2 oo 16000 4240 2 64 Ooo 12300 - enter en Last yea assub = 54000 tess fast pear depedion = (12320) Now Asetr 51200 . et =6S 0000 A Disposab Asser _ 5 e008 Quesh¢n Given Disp i fis Jax penedit on Loss 12.90% 3% Scanned with CamScannerHow to find norkiep Gbital Qe ky x > GA uegtion Working CopiteS lage ao Answer pee woven cited (| (1am) ( Co) (20) 100 () aap 2. A= Sneath en working ctl (oem) (12g 2a01) (Bas) (1601) 14) 600 of Aswan working, Ob ited (Jooea) (2400) 4o0o — Sagg Scanned with CamScanner" How to - ind Tax Pagabte in ome yy Wea Ye j ve ye L. = ll sofe : Soo tem medteicd i oe bepreiadia oe Tax a | " Scanned with CamScanner2. 2@ (1 De regus $ Inb4olvos)= 7 4 4 uygo (Io) = fan (1) » v y y S fio 40 (v08) Rr | Scanned with CamScanner, Illustration 3 — Dealing with inflation in NPV. calculations Accompany is considering a cost-saving project. This involves ! purchasing a machine costing $7,000, which will result in annual savings (in real terms) on wage costs of $1,000 and on material + costs of $400 | The following forecasts are made of the rates of inflation each year for the next five years: Wage costs 10% Material costs 5% General prices 6% | The cost of capital of the company, in money terms, is 15% | i | | Evaluate the project, assuming that the machine has a life of five) ' years and no scrap value. Solution To % T% Ts 1 Ts | $ $ $ $ $ $i | Investment (7,000) \ | Wages savings t | (inflating @ 10%) 1,100 1,210 1,331 1,464 1,610 | | Materials savings | | (inflating @ 5%) 420 441 463 486 510 | gertpen sabeptytas PET Net cash flow (7,000) 1,520 1,651 1,794 1,950 2,120 | | PV factor @ 15% 1.000 0.870 0.756 _0.658 0.572 0.497 | PVofcash flow (7,000) 1,322 1,248 1,180 4,115 1,054 Therefore NPV = $(1,081) which suggests the project is not worthwhile. ' Note: the general rate of inflation has not been used in, and is irrelevant to, this calculation. ” T Ty £ fee & Dh 2 le Penn ) L WAR temps) a pmb! " a io S x masa cot rnoxi9)) ts (as) wer? 255 Scanned with CamScannerTest your understanding 9 A business undertakes high-risk investments and requires a minimum expected rate of return of 17% pa on its investments. A proposed capital investment has the following expected cash flows: Year $% 0 (50,000) 41 18,000 2 25,000 2 20,000 4° 10,000 1 Calculate the NPV of the project if the cost of capital is 15%. Calculate the NPV of the project if the cost of capital is 20%. Use the NPVs you have calculated to estimate the IRR of the project. 4 Recommend, on financial grounds alone, whether this project should go ahead. DF: Year DF @ 15% 20% 1 0.870 0.833 2 0.756 0.694 3 0.658 0.579 4 0.572 0.482 7.2 Calculating the IRR of a project with even cash flows Scanned with CamScannerFG] Test your understanding 9 Year Cash flow DF pv DF py i 15% 28% 7 15% % % 20% Discount 4act ey 5 8 8 9 (60.000) 1.000 (60,000) 1.000 (50,000) q ula f» 18,000: 0.870 45,660 0.833 “tape am 2 25,000 0.756 18,900 0.694 47'309 a 3 20,000 0.658 = 13,160 0.579 41'5ay ) 4 10,000 0572 8,720 0.482 4.829 <4) NPV + 3,440 a th) The IRR is above 15% but below 20%. Using the interpolation method: peal sik, 1 The NPV is + 3,440 at 15%, ; (! +15! 2 The NPV is ~ 1,256 at 20%. Yay 3 The estimated IRR is therefore: IRR = 15% 440 x] (20 - 15% 7; =O :8%0 = 15% + be zs = 18.7% 4 The project is expected to earn a target rate of 17%. so on financial worthwhile investment. DCF return in excess of the grounds (ignoring risk) it is a Tee C TInteenal Rate Return ) , N Pidawer// Nae TRpae: , omer * arma =Coprrig NY Shho- C2sy) , TRB oy Spcg s Shae B4h0+ jxur6 A S/ TPR see le fh Buby doa s/) Scanned with CamScannerDiscounted Payback: —_—_—- < _ A discounted payback period is calculate 4 : din th period, with the exception that the cash flows of tro W2Y_a8 the ‘ordinary’ payback , ; s value. The discounted payback period is the Pee Project are converted to their present the project reaches Rs.0. of years before the cumulative NPV of Example # 07: investment i i 1 Ani rent in a new business venture is expected to have the following cash flows: Year | Annual cash flow Rs. (200,000) (40,000) 30,000 120,000 150,000 100,000 50,000 OORYON=0 Required: a) Calculate Payback period. b) -Calculate discounted payback period. Solution: a) Payback period: The payback period is calculated as follows: ‘Annual Gash flow] Cumulative NPV | Year: Rs. Rs. | 0 (200,000) (200,000) 1 (40,000) (240,000) 2 30,000 (210,000) 3° 420,000 . (0,000) 4 450,000 60,000 5 400,000 460,000 6 50,000 210,000 Payback occurs during Year 4. Since cash flows are assumed to occur at the payback ~~ period, it could be stated as Year ‘4. However, it is usual to estimate the payback périod in years and months. . The cumulative cash flows at the end of Year 3 are Rs.(90,000) and during Year 4, the, “cashflows are Rs.150,000. We can therefore estimate that if cash flows during Year 4 ‘Occur at a constant rate, the payback period is: Payback Period = 3 years + [(60,000/4 50,000) x 12 months) = 3 years and 4.8 months, - Payback Period.= 3 years 5 months. “The decision whether or not to invest.might depend on whether the NPV of the project is > positive and whether the payback period of 3 years and 5 months is acceptable. Scanned with CamScannerb) Discounted Payback Period: Annual Discount PV of Cumulative Year | Cash flow factor Seated Cash flow NPV Rs. ° Rs. Rs. 0___|(200,000) 7.000 (200,000) (200,000) 41 (40,000) 0.909 (36,360) (236,360) 2 30,000 0.826 24,780 (211,580) 3 | 120,000 0.751 90,120 (121,460) 4 150,000 0.683 102,450 (19,010) 15 100,000 0.621 62,100 43,090 6 50,000 0.564 28,200 71,290 + 71,290 The discounted payback period is Year 5, and we can estimate it in years and months 88: 4-years +,(19,010/62,100) x 12 months = 4 years 4 months. _ The discounted period for a capital investment is always longer than the ‘ordinary’ non- discounted payback period. One criticism of the discounted payback method of project evaluation is the same as for the non-discounted payback method. It ignores the expected cash flows from the project after the payback period has been reached. .One.meaéure of time to recover an investment.that recognizes the values of the cash flows over.the entire life of the project is duration. Scanned with CamScannerNPV Foymacte Yo D OnLy ase) Sate : So less mMacesad 30 Jobouy ld Fold rhein Prods bedere 76x " us —Tax © 10/ (44s) Predit after Tax YO + Pebwsoction © + vshng cal Ue) 8) + pispaseh valu New MAChiN Tax Benetit LosfGain) i en ce te ? + disposal ste Ash BOD Tax Lenefit py desea, aD Fr Ned Low : site eo SHE ye n 7) Fa bo loo ca So 0 So a a use 54e | (sc) bas) - 40g. Hoes S 5 Cw) (30 ea ~ eld Mos | ae sae} G2) Baap P67 GRE Fas Scanned with CamScannereyes IMA-DM- Winter-2011 Q.4) You have been just appointed as management accountant of Shan Electronics Limited. The company is considering investing in the production of an electronic security device, with an expected market life of five years. The following data has been.shown to you: Rs.'000' Proposed Electronic Security Device Project Years 08 0 4 2 3 4 5 . 7 2 dnvesimentin-depreciable fixed assets. Cumulativeavestmentin working capital 600 800 1,000 1.200 9,000 4,400 1,400 7,000 9,800 10,640 11,480 10,640 Materials 1070 1,500 1,800 2,100 1,800 Labour 2140 3,000 3,600 4,200 3,600 Overhead joo 200 200 200 200 ___100_ All the above cash flow and profit estimates have been prepared in terms of present day costs and prices. You have the following additional information: (i) Selling price and overhead expenses are expected to increase by 5% per year. (i) Material costs and labour costs are expected to increase by 10% per year. ~ (iii), Capital allowances (tax depreciation) are allowable. for: taxation purposes against profits at 25% per year on a reducing balance basis. (iv) Taxation on profits is ata rate of 35%, payable one year in arrears. (v) The fixed assets have no expected salvage value at the end of five years. (vi) The company’s after-tax required rate of return is 15%. Assume that all receipts and payments arise at the end of the year to which they relate, except those in year 0, which occur immediately. Working capital would release at the end of the project’s life. Scanned with CamScannerRecut Estimate the NPV of the proposed project. Justify whether it is @ Viable 7 14 (b) Facies Bea much the discount rate would have to change to yield a net present value (NPV) of approximately zero. 04 a Rs. ‘000? Year _ 1 2 3 4 5 Sales at 5% inflation (W-1) - 7,350 10,805, 12,317 13,954 13,580 - Materials at 10% inflation (1;177) (1,815) (2,396), (3,075) (2,899) * ’ Labour at 10% inflation (2,354) . (3,630) (4,792) (6,149) (5,798) Overheads at 5% inflation (105) (221) += (232) (243), (255) Capital allowances (dep:(W-2) (2,250) (1,688) (1,266) (949) (2,847) Taxable profits 1464 3,451 3,631 3,534 «1,783 Taxation at 35% 512 1,208 1,272 1,237 624 ———— (W-1): Year 1 = 7,000 (1.05) = 7,350 Year 2 = 9,800 (1.05)? = 10,805 Year 3°= 10,640 (1.05)° = 12,317 Year 4 = 11,480 (1.05)* = 13,954 _Xear 5= 10,640 (1.05)° = 13,580 The same approach is used to calculate the inflation adjusted cash flows for the remaining items using the following factors: —————— Inflation Factor @ Year1 Year2 Year3 Year4 Year5 5% 1.05 1.1025 1.1576 1.2155._1.2763 10% 14 1.21 1.331 1.4641 1.6105 25% writing down allowances on Rs. 9,000 with a balancing allowance in year 5. Rs. ‘000° Year Book value at Depreciation Accumulated Year end Beginning of the year @25% Depreciation Book Value 1 9,000 2,250 .. 2,250 6,750 2 6,750 1,688. * 3,938 5,062 3 5,062 1,266 5,204 3,796 4 £3,796 949 ; 6,153 2,847 5 2,847 2,847 9,000 0 Scanned with CamScannertroject Appraisal Methods | The cash fi ‘ow estimates and NPV calculation are as follows: Rs. ‘000° Year 0 7 2 3 7 ny F ~ 7,358 10,808 42,217 42,084 42,580 Materials ae (1,177) (1,818) (2.396) (3,075) Labour (2,354) (3,630) (4,792) (6,149).: Fixed assis (0,000) a = ee Working capital (600) (200) (200) (200) -«(200)-s«1,00—St—«— Taxation (612) (4,208) (1,272) (1237) (624) Total outflows (3836) (6,380) (6,628) (10,838) (6,788) (624) Net cash flows (8600) 3514 4,405 3.488 3,015 (4,701) (624) Discountfactors at 15% 1.0 0.870 0.756 0858 0.572 0.497 0.432 Present values (9600) 3,057 3,452,095 1,725 2,381 (270) ——————————————— The NPV is Rs. 2,933,000 and it is therefore recommended that the project should be undertaken, (b) Iculating the .IRR.will produce an NPV of zero. NPV is Rs. 2,933,000 at a 15% iscount rate. In order to use the interpolation method to calculate the IRR, it is ecessary to ascertain a negative NPV. At a discount rate of 30% the NPV is Cash flows Pv Year ‘000° factor ‘000° Rs. ‘000 30% Rs. ‘000’ 0 (9,600) 1.000 (9,600) 1 3,514 0.769 2,702 2 4,425 0.591 2,615 3 3,488 0455» 1,587 4 3,015 0.350 1,055 5 4,791 0.269 1,289 6 (624) 0.207 = (129) Using the interpolation method, the IRR is: _ Where, [ : a t At A-b - B-A) | A= Lower intrest rate | B= Higher interest rate 2,933 (30% - 15%) | #7 NPV of lover interest ate 15% + 3933 -(-481)_— * L Saas Scanned with CamScanner b= NPV of higher interest ratei . The company j ate ointed CFO of Sheikh & Company: r 7" Assume that you neve meet eduction of an electric security device with an expect mata i ve years. The previous CFO compiled the following al project, ? 2 3 4 5 Rs. ‘000 4,500 Investment " ap i it i 400 500 600 700 70 Sa investment in working capital 300 ag00 4,900 5,320 5470 52% Material costs 535-750 900 1,050 909 Labour costs 1,070 1,500 1,800 2,100 1,809 Overheads. 50 100 100 100- 100 Interest 576 576 576 576 576 Depreciation goo _-900 900 900 900 Profit before tax 369 1,074 1,044 1,014 1,044 Taxation @ 35% 129.376 365355365 Profit after tax 240. 698 ~=679 ~—«659 679 You have been provided following additional information. Scanned with CamScanner* The company gets tax dey i i preciation @ 25% . be applicable to the Company is 35%. Taxes are paid one year in arrears, a pd eee tiie requirements and overheads are expected to inflate fe Bi terial costs, labour costs are expected to increase by 10% per The company’s real after tax cost of capital is esti : pital is estimated to be 8% per nominal after tax cost of capital is expected to be 15% per annum. per annum and * Fixed assets have no expected residual value at the end of th i it 1e project. it capital would be recovered at the end of 5 years. : Project. Working ‘on written down value method. Tax Estimate NPV (net present vaiue) of the project on the basis of abave-data. Solution: 0 1 2 3 4 5 6 Rs. ‘000 Sales (W-1) 3675 5402 6,159 6977 6,790 - Material (w-2) (589) (908) (1,198) (1,537) (1,449) - Labour (W-3) (4,177) (1,815) (2,396) (3,075) (2,899) Overheads (w-4) (63) (110) (116) (122)(128)_—- Tax depreciation — (W-5) (1,125) (844) (633) (475) (356) - Tax loss on disposal (W-6) : : : = (1,068) Profit before Tax 731 1,725 1,816 1,768 ‘890 Taxation 35% = (256) (604) (636) (619) _(312) Profit after Tax o--.- 2.950 731 41,409 1,242-;,4,132°..° 271 (312) - Tax Depreciation cs 4125 844. «633.475 3568 a Tax loss on disposal “ ra i Sans 21,068 Ps Cost of investment’ + (4,800) ie ent, Working capital changes (W-7) (300) (120) (131) (144) (156) 854 Net Cash flows 74,800) 1,736 2,162 1,701 1451 2546 (312) PV factor @ 15% — (1+.15)" 4.00 0.870 0.756 0.658 0.572 0.497 0.432 Present Value —a800) 1,510 1,650 1,118 $30 7,265 (135) Workings: % (W-2) : Material ae " sae dations Rs. ‘000 Year Calculations Rs. ‘000 7 3500X (1.05) = 3,675 1 835X(1.10)"= 589 2 4900X(1.05).= 5,402 2° 750X (1.107 = 908 3 5,320X(1.05)° 6,159 3 900X (1.10) 1,198 4 5740 (1.05)'=" 6.977 ° 4 1,050 X(1.10)' = ier 5 5,320 (1.05) = 6,790 5° 900 X (1.10) = 1 P fee Scanned with CamScanner(W-3): Labour (W-4) : Overhead Year Calculations Rs. ‘000 Year Calculations Rs. ‘000 1 4,070X(110)'= 1,17 1 80x (1.05)"= 53 2 1,500X(1.107= 1,815 2° 100X (1.05)° = 140 3 1,800X(1.10)"= 2,396 3 100X (1.05)°= 116 4 2,100X(1.10)'= 3,075 4 100 (1.05)* = 122 5 4,800 (1.10)°= 2,899 5. - 100 X (1.05)° = 128 reciation & Loss on Disposal » od , ; Net Book, = Year Open cate ; Depreciation” Depreciation “yaiye @ end . pening Book value Rate forthe year of the year Rs.'000 % Rs.'000 Rs.'000 i 4,500 25 1,125 3,375 2 3,375 25 844 2,531 3 2,531 25 633 1,898 4 1,898 25 475 1,424 5 1,424 25 356 1,068 (w- 6) : Tax Loss on Disposal es se power Rs. ‘000 Disposal Value . . - Tax Written Down Value 4,500 (1-25%)" __(1068 Loss on Disposal (1068) w : Working Capital Changes Schedule: el Calculations ‘After Inflating @ 5% Net. Change 0 300X(1.05) = a feat 1 2 i i a } i : asi (8) 5 Recovery of WC — 8st Scanned with CamScannerExample # 03: ABC has just developed a new product to be called the lightening and is now considering whether to put it into production. The following information is available: (i) Costs incurred to date in the development of lightening amount to Rs.480,000 (ii) Production of lightening will require the purchase of new machinery at a cost of Rs. 2,400,000 Payable immediately. This machinery is specific to the production of lightening and will be obsolete and valueless when production ceases. The machinery has a production life of four years and a production capacity of 30,000. units per annum. ~- 5 (i) Production casts of lightening (at year 1 prices) are estimated as fotlows:~ Rs. Direct material 8.00 Direct labour 12.00 Variable overheads 12.00 In addition, fixed production costs (at year 1 prices), including straight-line depreciation on plant and machinery specific to this project, will amount to Rs. 800,000 per annum. (iv) The selling price of lightening will be Rs.80.00 per unit (at year 1 prices). Demand is expected to be 25,000 units per annum for the next four years. (v)_ The retail price index is expected to be at 5% per annum for the next four years and the selling price of Lightening is expected to increase at the same rate. Annual inflation rates for production costs are expected to be as follows: % Direct material s Direct labour . 10 Variable overheads 4 Fixed costs 5 (vi) The company's cost of capital in money terms is expected to be 15%. You may ignore the effects of taxation. Unless otherwise specified all costs and revenues should be assumed to raise at the end of each year. Required: : Calculate whether ABC Lid. should produce lightening on the basis of the information above. Scanned with CamScanneree Rs. 480,000 development Depreciation is not a cash flow and sho! 2,400,000 _ = 600,000 per annum cost is a Sunk Cost. uld be excluded from the fixed costs, Depreciation = 4 years 0 1 2 3 4 R007 ital it 400} - ee qwety (2400) 000 2,100 2,205.. 2,315: ns Direct material < * (W-2). (200). (208)...., (216). (225) Direct Labour - (w-3) * (300) (330) (363) (399) = Variable Overhead “ — (W-4) (300) (312) (324) _~— (337) " Fixed costs (W-5) (200) (210) (221) __(232)_ Net Cash Flow (2400) 1,000 1,040 1,081 1,122 45% Discount Factor _(W-6) 1.000 0.8696 0.7561 0.6575 0.5718 ~ Present Value : (2,400) 869.6 786.4 710.8 641.5 Net Present Value is Rs. 608,300, Therefore the company should invest in the.project. ayes : ai Workings: : (W-1) : Revenue (W-2) : Direct Material Year Calculations Rs. ‘000 Year Rs. ‘000 ns : 1 2,000X(1.05)"= 2,000 1 = 200 2 2,000X(1.05)""= 2,100. 2 x = 208 3 2,000X(1.05)""= 2,205 3 200X(1.04)*" = 216 4 2,000X(1.05)""= 2,315 4 200X(1.04)"' = 225 (W-3) : Direct Labour (W-4) : id Year Calculations Rs. ‘000 Ne : Wetahie Qrerhes Rs. ‘000 4 300 1 300X(1.04)""= 300 3 S30 2 300X (1.04) 312 “4 3 3 300X (1.04) 324 0 399 4 300X(1.04)*' = = 337 -5) : Year Re. 000 (W-8) : Discount Factors 7 a Year Caiculations Factor, 200 1 5)" 2 210 (1.15)" = 0.8696 3 4 an 2 (1.15)? = 0.7561 4 200X (105)""= poe 3 (1.15)8 = 0.6575 Note: 4 (1.15)* = 0.5718 In Working 1 to 5, ¥ . Year 1 is Base year therefore, for easy & simple'calcutation: it must be year (n)- Scanned with CamScannerThe management of a firm is considering an investment project costing Rs.150,009, * and it will have a scrap value of Rs.10,000 at the end of its 5-year life. The . transportation charges are expected to be Rs. 5,000 and installation charges are expected to be Rs. 25,000. If the project is accepted, a spare parts inventory of Rs, 10,000 must also be acquired and maintained. It is estimated that the spare parts will have an estimated scrap value of 60% of their initial costs after 5 vears. Annual revenue from the project is expected to be Rs.170,000 and annual labour, material and maintenance expenses are estimated to be Rs.15,000, Rs.50,000 and Rs.5,000 respectively. The depreciation and taxes for each of the five years will be as follows: Rs. Year Depreciation Taxes = 4 72,000 11,200 2 43,200 22,720 3 32,400 27,040 4 21,600 31,360 5 800 39,680 2 Required: Calculate net cash flows for each year and initial cash outflow of the project. Evaluate the project at 12% rate of interest. 17 Solution: Cost of the project: Rs. ig wc: Cost-ofthe.Project 150,000 =" Kidd: ~Transportation charges 5,000 “Installation charges 25,000 180,000 Add: Spare parts inventory to be maintained 10,000 Total cost of the project . 490,000 Eamings Before Depreciation and Tax: Rs. ‘Annual Revenue from the project 470,000 Less: Annual Expenses: Materials 50,000 Labour 15,000 Maintenance Expenses 5,000 70,000 Earnings before depreciation and taxes 700,000 Scanned with CamScannerEamings Earnings Earnings Net Cash flows Year Before jeprec Before Taxes after —_(earnings after taxes Depreciation '"°" taxes Taxes _plus depreciation) & Taxes 7 700,000 72,000 28,000 17,200 16,800 88,800 2 100,000 43,200 56,800 22,720 34,080 77,280 3 100,000 32,400 67,600 27,040 40,560... 72,960." 4 100,000 ~~ 21,600. 78,400 31,360 . 47,040 : .- 68,640" 5 100,000 800° 99,200 39,680 ~ 59,520 * 60,320 Salvage value at the end of the 5" year Rs. Salvage value of the project 10,000 Salvage value of the spare parts 6,000 Total 16,000 Statement Showing Evaluation of the Project at 12% rate of Interest i Presi Year Net Cash Flows iseouns Factor pee at 0 (190,000) 4.000 (190, 000) 1 88,800 0.893 79,298 2 ” 77,280 0.797 61,592 3 72,960 0.712 51,948 4 68,640 0.636 43,655 5 76,320 (N-1) 0.567 43,273 Net Present Value 89,766 (N-1) Net Cash Flow in the 5th year due Earnings Rs. 60,320 + Salvage value Rs. 16,000 The project is acceptable because net present value is positive Q.14 National Cosmetics Limited has paid Rs. 1,000,000 towards a market research. After conducting the research activity company has decided to: undertake “a project for: launching a new line of product. Project requires an initial cash outlay of Rs. 5,000,000. towards fixed assets and Rs. 1,500,000 towards working capital requirement (80% of working capital will be recovered at the end of project). Estimated life of the project would be 5 years and residual value of fixed assets at’ the end of project's life would be Rs. 500,000 after providing depreciation on straight- line basis. Company's cost of capital is 13.50%, tax shield on depreciation is Scanned with CamScannerdue to a recent notification company erywye san exempta, e . However, imated li ; ee of ive (5) years. Profs before tax throughout he estima Moot Proce, present value factor at 13.50% per annum are given below: Year Profit (Rs.) PV Factor at 13.50% 7 3,500,000 0.8811 2 4,500,000 0.7763 3 4,500,000 0.6839 4 4,000,000 0.6026: 5 _ 500,000 0.5310 3 Required. 5, sunein +" Work out the net present value of the project. 10 Solution: Statement showing net present value: D ‘ation Net Cash Pv Present Va epreciati Year Profit P Inflows of-Tota| Working) (proftsDep.) 8%” Cashin 1 3,500,000 900,000 4,400,000 0.8811 3.8763 2 1,500,000 900,000 2,400,000 0.7763 1,863 3 4,500,000 900,000 5,400,000 0.6839 3,693,0 4 4,000,000 900,000 4,900,000 0.6026 2,952, 5. 500,000 900,000 1,400,006 0.5310 7434 5 80% of working capital 1 1,200,000! 0.5310 637,20 5 Residual value of F-Assets 500,000! 0.5310 265,50 Present Value of Total Cash inflows Less: Initial Cash outlay: For Fixed Assets For Working Capital Requirement Net Present Value of the Project Working: Cost of Fixed Assets Less: Residual Value Amount Attributable to Depreciation Life of the fixed assets (years) Depreciation Per year. 14,031.86 5,000,000 . 1,500,000 _ 6,500,000 7,531,860 5,000,000 500,000 p00, ——F — it, =< initiation of Proj Pp i ¥ ision on the prope lect, so.it has been ignored for the Scanned with CamScannerSe een URN UE UG pregeess sag R&. 150,000. The equipment pment costing *°- ‘A company is considering an investment in an item of qVIPMEN Y' oday's prices would be Rs. 10 per would be used to make a product, The selling price of the P' uit, and the variable cost per unit (all eash costs) would be RS. be: The project would have a four-year life, and sales are expected 10 ‘Year Units of sale 1 20,000 2 40,000 3 60,000 4 20,000 4 for Rs. 10,000. There. At today’s prices, it is expected that the equipment will be sold at the eed a roject, a today's orice will be additional fixed cash overheads of Rs. 50,000 each year as a result of the project, levels. The company expects prices and costs to increase due to inflation at the following annual rates: Item Annual inflation rate Sales 5% Variable costs 8% Fixed costs 8% Equipment disposal value 6% The company’s money cost of capital is 12%. Required: Calculate the NPV of the project. OnRSTION.11 Scanned with CamScannerANSWER-10 To tT - 3 1: Sales 210,000 441,000 694,575 243,101 Less: Variable Cost (129,600) (279,936) (453,496) (163,259) ‘Less: Fixed Cost (54,000) (58,320) (62,986) (6.025) ital i 150,000) {nitial investment ¢ Residual Value 12,625 ‘Net Cash Flow (150,000) 26,400 102,744 178,093 24,442 Discount Factor @12% 1 0.893 0.797 on 0.636 > (450,000) 23,575 31,887 126,802 15,543 NPV Rs.97,809 Project should be accepted, as NPV is positive. Scanned with CamScannerQUESTION-17 The fellowing draft apprai appraisal of a proposed i ‘ of OKM Co by a trainee cent investment project has been prepared for the finance director OKM Co. project is consistent with the current business operations of Year 1 Sales (units/year) 2 3 4 5 lyear) 250,000 400,000 500,000 250,000 Contribution Rs. 000 Rs.000 Rs. 000 Rs. 000 Rs. 000 Fixed coats ea 2,128 2,660 ‘1,330 ost 530) (562) (596) (631) Depreciation ee payments 1438) (438) (437) (437) joable profit (200) (200) __—(200)__—(200) boc 162 928 1,427 62 ae OD eC Profit after tax 162 879 1,149 (366) (1) Scrap value 250 After-tax cash flows 162 379,149,416) 9). Discount at 10% 0.909 0826 _0.751_0.683_0.621 Present values 147, 726 863 79) az Net present value = 1,645,000 - 2,000,000 = (Rs. 335,000) so reject the project. The following information was included with the draft investment appraisal: 1. The initial investment is Rs2 million 2. Selling price: Rs. 12/unit (current price terms), selling price inflation is 5% per year 3. Variable cost: Rs. 7/unit (current price terms), Variable cost inflation rate is 4% per yea. 4. Rs. 200,000/year of the fixed costs are development costs that have already been incurred and are being recovered by an annual charge to the project 5. Investment financing is by a Rs. 2 million loan at a fixed interest rate of 10% per year OKM Co can claim 25% reducing balance capital allowances on this investment and pays taxation one year in arrears at a rate of 30% per year 7. ‘The scrap value of machinery at the end of the four year project is Rs. 250,000 8 Thereal weighted average cost of capital of OKM Co is 7% per year 9. The specific rate of inflation is expected to be 4.7% per year Scanned with CamScannerRequired: | (@) Identify and comment on any errors in the investment appraisal prepared by the trainee accountay (©) Prepare a revised calculation of the net present value of the proposed investment project ang comment on the project's acceptability. QUESTION-18 BQK Co, a house-buildin, build 100 houses on a development site over the next f 1g company, plans to buil our years, The purchase cost of the development site is Rs. 4,000,000, payable at the start of the first year op Construction. Two typos of house will be built, with annual sales of each house expected to be as follows ‘Year 1 2 4 Number of small houses Sold: 15 2B os Number of large houses sold: 7 8 1515 Houses are built in the year of sale. Each customer finances the purchase of a home by taking w. € term personal loan from their bank. Financial information relating to each type of house is as fo. Small house Larg: * ouse Selling price: Rs. 200,000 Rs. 350,000 Variable cost of construction: Rs. 100,000 Rs. 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 Rs. 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. BOK 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. BOK 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. Required: Calculate the net present value of the proposed investment and comment on its financial acceptability. Work to the nearest Rs. 1,000. QUESTION-19 HDW Co isa sted company which plans to meet increased demanc i “ machinery costing Rs5 million. The machinery would last for four van the ee Sh ene replaced. The scrap value of the machinery is expected to be 5% of the initial cost, Capital allowances would be available on the cost of the machinery on a 25% reducing balance basis, with belanc allowance or charge claimed in the final year of operation, asis, with a balancing This investment will increase production capacity by 9,000 units pecan toa n on cui ae expected to be sold as they are produced. Relevant financial i et t s aaa ial information in current price terms is #8 Selling price Rs. 650 per unit Forecast inflation Variable cost Rs. 250 per unit 4.0% per year ss Incremental fixed costs Rs. 250,000 per year 5.5% per year (dition to the initial cost of the new machinery, initial i 7 , 5.0% per year wate required, Investment in working capital will be subject treet ot Working capital of Rs, $00,000 a expected to be 4.7% per year. Subject to the general rate of inflation, which is _——————— Scanned with CamScannerHDW Co pays (none EES) afer ROMS atthe rate of 20% per Yeats Cost of capi " Calculate the net py capital of 12% per year. : minal terms) approach ang cc" Value of thi the new machinery using 4 NO nd com 1¢ planned purchase of mer a ‘nt on its financial acceptability. one year in arrears. The company has a nominal ne (money 0 Ufiin Co is a large com, \ Pany which j th investment proposal to macy tch is listed on a major stock market. The company has been evaluating atthe start of the first mat™facture Product K3J. The initial i aint of Rs, 1,800,000 will be payable year |. The initial investms employee. f operation. The following draft evaluation has been prepared by @ junior Year Sales (units/year) 1 2 3 - Selling price (Rs/unit) 95,000 100,000 150,000 150,000 ‘Variable costs (Rs/unit) 25 25 26 27 u 12 12 13 ite: The above selling price: , we sand variable costs per unit have not been inflated.) sales revenue Rs.000 Rs,000 —-Rs.000 Rs. 000 Variable costs 2,475 2,605 4,06¢ 4,220 Fixed costs (1,097) (1,260) (1,890) (2,048) Se pajraenls (15s) (155) (ss) 55) sca before tax (150) 150 150) 150) Cas ner 1,073 1,040 1,869 1,867 Tax allowable depreciation 450 450) 450 450 Cee 623 590 1,419 1,417 37) (30) G12) Netcash flow | 623 453 1,289 1,105 Discount at 12% 0.893 0.797 O72 0.636 Present values 556 361 18 703 Rs. 000 Present value of cash inflows 2,538 Cost of machine (1,800) NPV 738 The junior employee also provided the following information: (l) Relevant fixed costs are forecast to be Rs. 150,000 per year. @ Sales and production volumes are the same-and no finished goods inventory is held. () The corporation tax rate is 22% per year and tax liabilities are payable one year in arrears. © Uftin Co can claim tax allowable depreciation of 25% per year on a reducing balance basis on the initial investment. ‘4 Abalancing charge or allowance can be claimed atthe end ofthe fourthyear. Itis expected that selling price inflation will be 4.2% per year, variable cost inflation will be 5% cy Reyear and fixed cost inflation will be 3% per year. ® ie investment has no scrap value. . ® un investment will be partly financed by a Rs. 1,500,000 loan at 10% per year. \ Reguireds Co has a weighted average cost of capital of 12% per year. i este . : cere draft evaluation of the investment proposal and comment on its fi l ility, Solin any TWO revisions you have made to the draft evaluation in part (a) above. Scanned with CamScanner inancialars in the Original investment appraisal 0 lation incorrectly avon: ee . . 7 since only one year applied te selling prices and variable costs in calculating contribution, year's inj ‘ * The fixes lation was allowed for in each year of operation. e gE = 5 faPital allowances should he ngs eee interest payments have been included in the investment a The pnt fate used in calculating the ne Present value, ce ee on the debt finance has been used as the discount rate, when the nominal weight flows °°" OF Capital should have been used discount the calculated nominal after- ppraisal, but these are allowed for by the (b) Nominal weighted average cost Of capital = 1.07 x 1.047 NPV calculation: To Tt Sales - Variable Cost : = 1.12, ie. 12% per year Th Ts Ts 3,150,000 5,292,000 Ts 6,945,750 3,646,519 (1,820,000) (3,028,480) (3,937,024) (2,047,252) ~ _ 1;330,000 "2,263,520 3,008,726 1,509.267 Fixed Cost ~___ 330,000) _ (349,800) (370,788) (393,035) : Depreciation = __ (500,000) (375,000) 281,250) (693,750) 5 500,000 "1,538,720 2,356,688 612,482 = Tax@30% - ~ (150,000) (461,616) (707,006) 183,745 Depreciation = 500,000 375,000__-281,250 593,750 : 1,000,000 1,763,720 2,176,322 499,216 (183,745) Loan , 2,000,000 - - - Ce) . ne ean 1,000,000 1,763,720 2,176,322 (1,250,784) (183,745) 1 (6, 12) (140.12)? (140.123 (140.124 (140.12) PV@12% x 1 1 (1+0.12) 892,857 1,406,027 1,549,063 (794,896) (104,262) _ NPV=Rs, 2,948,789 - Tax Depreciation: Rs. T; 2,000,000 , . 500,000 T\ Depreciation (2,000,000 x 25%) at 000 Th Depreciation (1,500,000 x 25%) _(375,000)_ ymin Scanned with CamScanner“Ts Depreciation (1,125,000 x. 25%) _(281,250)_ 843,750 Te. (Bal, fig) 595.755} 250,000 ANSWER-18 (a) NPV calculation 3 4 5 Year Z 2 00 «Rs. 000 Rs.000 Rs.000 Rs. 0 + Rs. 000 7,034 5,614 7,214 9,015 ° eae 3031) 931) (5,135)__(4,174) _ 6031) G93) OB) ait 2,583 3,283 3,880 2,860 an 1530) (1,561) (1,592) (1,624) Depreciation — (000) (1,000) (1,000) (1,000) Before-tax cash flow 3 722 288 236 Tax liability (16) (217) (386) (71) Depreciation 1,000 1,000 1,000 1,000 ee After-tax cash flow 1,053 1,706 2,071 850 (71) Discount at 12% 0.893 0.797 0.712 0.636 0.567 TOT 9636 0.567 Present values 940 1360 1,475 5410) NPV = 276,000 Comment Since the proposed investment has a Positive net present value of Rs. 276,000, it is financially acceptable. Workings: Sales revenue Year 1 2 3 4 Sales of small houses (houses/yr) 15 20 15 5 Sales of large houses (houses/yr) 7 8 1515 Small house selling price (Rs000/house) 04 Large house selling price (Rs000/house) i 300 sr fa Sales revenue (small houses) (Rs000/yr) Sales revenue (large houses) (Rs000/yr) at se oad tas0 Total sales revenue (Rs/yr) 3450 on 3250 G50 Inflated sales revenue (Rs/yt) Ed 9a 5,614 7,214 9,015 _7,034 Sold 7,214 9,015 _ 7,034 Variable costs of construction Year 1 2 3.34 Sales of small houses (houses/yr) 15 20 15.5 .. Sales of large houses (houses/yr) 7 : 5 OB Small house variable cost (Rs. 000/house) 100 100 100 100 Large house variable cost (Rs. 000/house) i 200 200 200 2 Scanned with CamScanner1,500 2,000 1,500 500 Variable cost (small houses) (Rs. 000/yr) ; 10 1,400__1,600_3,000_3,00 Variable cost (large houses) (Rs, 000/yr) : 3,600 4,500 3,500 Total variable cost (Rs. /yr) Spo aasi 438404 Inflated total variable cost (Rs. /yr) _ 3031 3931S ANSWER-1! @) Net present value of investment ‘new machinery 2 3 4 5 . Rs.000 —Rs.000 Rs. 000 Rs. 000 ~—-Rs.000 Rs. 000 Sales income 6,084 6,327 6,580 6,844 Variable cost 2,374) (2,504) (2,642) (2,787, Contribution 3,710 3,823 3,938 4,087 Fixed costs 263; (276) 289) 304 Cash ae 3,447 3,547 _-3,649_—_—«3,753 Capital allowances (1,250) (938) (703) (1,859) Taxable profit 2,197 2,609 2,946 1,804 Taxation (439) (522) (S89) G79) era Profit 2,197 2,170 2,424 1,305 G79) Capital allowances 1,250 938 703 1,859 After-tax cash flow 3,447 3,108 3,127 3,164 (79) Initial Investment (5,000) eae Working capital (500) (24) (25) (26) 574 Scrap value 250 Net cash flow (5,500) 3,433 3,083 3,101 3,988 379) Discount at 12% 0.893 0.797 0.712 0.636 0.567 Present values 3,057 2,457 2,208 2,536 (215) NPV = 10,043 - 5,000 - 500 = Rs, 4,543 million As the net present value of Rs. 4,543 million is positive, the expansion can be recommended as financially acceptable. Workings Year 1 2 3 4 Selling price (Rs. /unit) 676.00 703.04. 731.16 760,41 Sales (units/year) 9,000 9,000 9,000 9,000 Sales income (Rs. 000) 6,084 6,327 6,580 6,844 Year 1 2 3 4 sassy was mans hse a9 Weible cost Rs. 000) ci 2,504 2602 281 Rs. 000 Rs. 000 Rs.000 Rs. 000 Wotking capita 523.50 548.11 973.87 neremental 24 25 26 (874) Scanned with CamScannera it osal : draft evaluation of investment PFroP : F 3 . oe Rs. ‘00 Rs. 000 Rs. 000 Rs. 000 Rs. 000 Rs. 000 RSM Tia AIS ALTTS arate cost caer) 323) @,08) 370 ( 159 oe 3,165 2,236 Variable costs Fixed costs 3 1,232 Cash flow before tax Le 338 (253. 759 inti 850 1,912 1,477 Tax Depreciation 73 394 * 7 Taxable profit am 09 421) 25), 724 1,715 1,056 325) Taxation 73 After-tax profit 450 338 253 759 ‘Tax Depreciation Cost of Machine ry ves) Loan . 1,223 1,062 1,968 315° (325) Beet gos 0797_O.712._0636__ 067 Present values 1,092 846 1,401 200 (184) NPV =3,055,000 tee s that a positive net present value is The revised draft evaluation of the investment proposal indicate: t expected to be produced. The investment project is therefore financially acceptable and accepting it will increase the wealth of the shareholders of Uftin Co. Workings: Wel ‘Year 1 2 3 4 Sales (units/year) 95,000 100,000 150,000 150,000 26.05 27.14 29.42 31.83 Inflated Selling Price (Rs. /unit) Sales revenue (Rs. 000/year) 2475 -2,714 4413 4,775 w-2 Year Sales (units/year) Inflated Variable Cost (Rs. /unit) 1 2 3 4 95,000 100,000 150,000 150,000 11.55 13.23 13.89 15.80 Variable costs (Rs. 000/year) 1,097 1,323 2,084 2,370 w-3 Rs. To 1,800,000 T; Depreciation (1,800,000 x 25%) _ (450,000) 1,350,000 To Depreciation (1,350,000 x 25%) _(337,500) 1,012,500 Ts Depreciation (1,012,500 x 25%) _ (253,125) 759,375 (759,375) Ty Depreciation (Bal. fig) Scanned with CamScanneri Cab Servi ON is consideri nvestment proposal from Burraq ices imi sidering an 1 : ey ieee een ore aide branded cars to BCS under the following terms and (BCS). As per the Pp i os would pay rent of Rs. 1.8 million per annum ee or to MTL. The cars would operate on a t it ' t the end of year. te oe Pay ot ofthe car would initially be paid by BCS but would be (i st of the drivers an¢ i ® eased against car rentals payable to MTL at ‘the end of each year. (ii) MTL would provide a smart mobile to each driver. (15.50) (15.50) (6.50) 6.50) Operating expense (10%) z (7.75) (7.75). G.25)_ B.25) 5% of sales for technical support by CL 175.00 7 - = 100.00 Investment (175.00) 3aa5. 54.25 22.75 122.75 hee oe ey 100 0,870.76 _——0.66__—0.87 iscount factor 75.00) 47.20 4123__(15.02__ 69.97 Present value 175,00)_47.20 Net present value at 15% NPV, __(1.58)_ a nee 7 2 oe Discount factor (12%) aes ae Present value 175.00) 48.28 42.86 16.15 7738 Net present value at 12% NPVs = nae ; , Internal rate of retum (IRR) = Lower rate% + 7S tower -NPV at higher * (high-lower)% = 15% + [-1.58 + 1.58 - 9.62)1 x (12% - 15%) = 14.58% ANSWERS-5S Diamond Investment Limited (1) Net Present Value (NPV) of the project Year0 Yearl Year2 Year3 Year4 Cash inflows/(outflows)-Rupees in million Sales - 300.00 333.90 371.63 413.62 Cost(Sales+1.25) - (240.00) (267.12) (297.30) (330.90) Plant depreciation at 25% of WDV - (32.00) (25.60) (20.48) ~—(16.38) Net profit - 28.00 41.18 53.85 66.34 ee - - 9.52) (14.00). (18.31) 22.56) : back depreciation = 32.00 25.60 20.48 16.38 Cost of plant and its installation (160.00) = ~ . 65.54 Working capital (20.00) : 2 E 20.0 Projected cash flows (180.00) "50.48 52785602 (145.1 PVfactorat 8% 1.00085 0.72 0.61 0.5; 085 07261 Present value (180.00) 42.91 38.00 34.17 75. NPVatl8% a PV, : a aterm Rate of Return (IRR) of the project: PV factor at 22% 00 pe per 35 pas [Pv at 22% (Projected cash flow * Millon #35 $536 pus 1557 Rs. (6. illion PV at 22% (NPV) avatiower Rate x (high-lowen)% = Lower rate% + Spyatlower -NPV at higher m = 199+ [10.84/10.84— C687) x 22% 1870 IRR= 20.45% Scanned with CamScannerANSWERS.¢ Cnlga Limitea let present value of the pro} project YearQ 1 2 3 48 6 Cash inflows/(outflows)-Rs.in million Sales(10%growth) 5 #5 300.00 330.00 363.00 399.30 439.23 Cost of goods sold (8% growth) en ‘ (195.00) (210.60) 227.45) 245.64) 255.09) pleGhantn ‘00 0.90) (1089) (11.98) (3.18) , von ) ) ? = 70.00 Factory building (4000) sg” Plant installation 80 om 73.00 Loan 50.00 : : e = 0.00) Working capital 115.00) z 5 5 = 15.00 ‘Net cash flows (50.00) (85.00) 96.00 109.50 724.66 141.68 220.75 pen 100089 oan omt__0et_ 057 Present value Go.0) 75.65) __76.80__77.75_79-78 80.76 _ 112.58 £50.00) _(75.65)_P0 77.78 __79.78_80.76 _TUe Net present value of the project is Rs. 302.02 Million. Workings: Cost of goods sold: Rs.in million Cost of own production (Including depreciation) (300 * 80% * 90%) 216.00 Depreciation - factory building (30 ~ 50%) = 5 (3.00) Depreciation - Plant (100 * 90%) * 5 (18.00) —__ 195.00 ANSWERS To T th Ts Ts —— Rs in Million —— Seles 800 1,100 1306.8 1,543.96 Less: V. Cost (640) (880) (1045.4) (1,235.17) Contribution Lost (X85) (1) 24.2) G9.93), 8.56) Inc. Fixed cost G0) . 3) (363) 9.93) Dep. ara | 438) _ 63.28) _ 67.40)_ ‘Taxable profit 65. 7842 121.84 — 162.83 Tax@30% (1.95) (23.53) (36.55)_—(48.85) ‘Add: Back tax dep. 1125 84.38 63.28 47.46 Initial investment F450) 2 ey oe ig eT Net cash flow (450) 117.05 13927 «148.58 (303.81 DF-12% 1 0.893 0.797 0.712 0.635 PV (450) 104.53 110.99 105.78 192.933 NPV Rs. 64.126 Million ora 1 0.833 0.694 «0.578 (0.482 NPV =- Rs. 23.385 Million (450) 9715 96.65 86.025 146.44 Scanned with CamScannerWt wreciation ee Cost 450 Tt Dep. 25% (112.5) 3375 th Dep. 25% (84.38) : 253.12 Ts Dep. 25% (63.28) 189.84 TH Dep. 25% (47.46) 142.38 — NPVat lower Rate ' RR = rate% +—_NPVatlower Rate____ -lower)% 7 Tower rates’ * NpVat ower -NPVarhigher * (High lower)% = 64.126 9 12% + ae (20-12) = 12% + 0.732(8)% = 12% + 5.86% IEIRR greater than cost of capital = Accept ANSWERS-8 @) Investment and speculation are similar in that they both involve an investor to take risk in the > following are the main differences between investment and speculation: investment [Speculation @ [Normally investments are made for Speculation is often made ‘on short term basis. long-term periods. cH) ae of investor in investment is peculation always involves high risk. sually risk neutral. (iii) Investment usually involves putting money into PP eculators often inv est in more marketable assets the asset that isn’t typically marketable in the ey do not plan to own them for long time. hort term. The objective is to yield a series of retums over the life of the investment, (4) [investors build their strategy based on the Speculators normal bxpectation that a certain price movement or ith jincome stream will occur. ly expect some kind of change ‘out necessarily knowing what, (©) [There isa low to moderate risk involved in Risks usually moderaie to high in speculation. investment. (vi) [investment involves moderate returns due to low ipeculation involves high returns in exchange for F moderate risk. igh risks, L Scanned with CamScanner