AMAB 223 Management Accounting

DECISION MAKING ON CAPITAL EXPENDITURE

Learning Outcomes
At the end of this lecture, students should be able to:
1. Identify objectives of capital budgeting
2. Illustrate and apply various capital investment appraisal methods
3. Evaluate mutually exclusive projects with unequal lives.
4. Explain capital rationing and select the optimum combination of investments when capital is
rationed for a single period.
5. Calculate the effect of taxation on capital investment.
6. Apply sensitivity analysis to capital investment appraisal decision.
7.
Introduction

 The term capital budgeting refers to the procedures that are used by firms to allocate scarce
capital to investments in productive capacity that are expected to generate cash flows over a
given future period.
 While each capital investment project is in some sense unique, a common set of principles can
be used to apply the investment appraisal methods to a wide range of investment alternatives.
These principles are illustrated by the example that follows
 The general idea is that the capital, or long-term funds, raised by the firms are used to invest in
assets that will enable the firm to generate revenues several years into the future
 Often the funds raised to invest in such assets are not unrestricted, or infinitely available; thus
the firm must budget how these funds are invested.
 The objective is to accept all those investments whose returns are in excess of the cost of capital.
 A firm should invest in capital projects only if they yield a return in excess of the opportunity cost
of an investment (also known as the minimum rate of return cost of capital, discount/hurdle
rate).
 Opportunity cost of investment = returns available to shareholders in financial markets from
investments with the same risk as the project.

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 Objectives of Capital Investment Decision
 With any decision it is vital to understand what is to be achieved in the first place as this will
influence the method to be used.
 The most common objective in investment appraisal is to maximise shareholder value. This is
because most decisions are made by companies where the directors have a duty to act in the
interests of their shareholders.
 Factors that need to be incorporated in order to maximise shareholder value:
1. Cash is preferable to profit - cash flows have a higher impact on shareholder wealth than
profits.
2. Exceeding the cost of capital - The return must be sufficient to cover not just the cost of debt
(for example by exceeding interest payments), but also the cost of equity.
3. Managing both long and short-term perspectives - Investors are increasingly looking at long-
term value. When valuing a company’s shares, the stock market places a value on the
company’s future potential, not just its current profit levels.
Company announcements – about capital expenditure, research and development, or new
investments – are often treated as positive rather than negative factors by the market, even
though these announcements may have a detrimental effect on short-term profits. New
biotechnology companies, for example, clearly have a value despite the fact that many
currently have no products.
Taken together, these would suggest the use of discounted cash flow techniques such as net
present value and internal rate of return.

 Improving profitability
o Despite a poor correlation with shareholder value, many businesses focus on increasing
profit. This is due mainly to familiarity and simplicity.
o Popular profit based measures include return on capital employed and accounting rate of
return

 Other objectives
 Many other objectives can be incorporated into decision making.
1. Liquidity concerns can be incorporated by setting a target payback period
2. Trying to simultaneously maximise return while minimising risk.
3. Some objectives are very difficult to quantify (e.g. impact on quality of life of local
residents when appraising a decision to build a new shopping centre)

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 Project Classifications
 Capital budgeting projects usually are classified using the following terms:
1. Replacement decision
 A decision concerning whether an existing asset should be replaced by a newer version
of the same machine or even a different type of machine that does the same thing as
the existing machine
 Such replacements are generally made to maintain existing levels of operations,
although profitability might change due to changes in expenses (that is, the new machine
might be either more expensive or cheaper to operate than the existing machine)
2. Expansion decision
 A decision concerning whether the firm should increase operations by adding new
products, additional machines, etc.
3. Independent project
 The acceptance of an independent project does not affect the acceptance of any other
project i.e. the project does not affect other projects
 For example, if you have a large sum of money in the bank that you would like to spend
on yourself, say RM150,000. You decide you are going to buy a car that costs about
RM30,000 and a new stereo system for your house that costs less than RM5,000. The
decision to buy the car does not affect the decision to buy the stereo because they are
independent decisions
4. Mutually exclusive projects
 The decision to invest in one project affects other projects because only one project can
be undertaken
 For example, if in the above example you have decided you were going to buy only one
car, but you were looking at two different types of cars, one is a Chevrolet and the other
is a Ford. Once you make the decision to buy the Chevrolet, you have also decided you
are not going to buy the Ford.

What is a “cashflow”?

 In order to make any type of financial decision, you must first know what the relevant cashflows
are that must be evaluated.
 In the case of a capital budgeting decision using Net Present Value (NPV), you must know which
cashflows must be discounted.
 The analysis must be based only on relevant cost. Only incremental cashflows (either into or out
of the firm) that will be different if a project is undertaken should be included as cashflows in the
analysis.
 An opportunity cost is a type of cashflow that is incremental and must be considered when making
a capital budgeting decision. By using an asset in a certain project, a firm gives up the chance to
use it in other ways. This is the opportunity cost of the project.
Example: A firm is considering leasing out a warehouse that it owns. If it leases it to someone else,
the firm cannot use it for its own production. The profits that the firm could have made by using
the warehouse itself are the opportunity costs of leasing it out.
 Therefore irrelevant cost such sunk cost should be ignored in capital budgeting decisions.

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 Capital Budgeting Evaluation Techniques
 Before committing to high levels of capital spend, companies normally undertake investment
appraisal.
 Investment appraisal has the following features:
1. assessment of the level of expected returns earned for the level of expenditure made
2. estimates of future costs and benefits over the project's life.
 When a proposed capital project is evaluated, the costs and benefits of the project should be
evaluated over its foreseeable life. This is usually the expected useful life of the non-current asset
to be purchased, which will be several years. This means that estimates of future costs and
benefits call for long-term forecasting.
 A problem with long-term forecasting of revenues, savings and costs is that forecasts can be
inaccurate. However, although it is extremely difficult to produce reliable forecasts, every effort
should be made to make them as reliable as possible.
 Appraisal methods normally used in long-term investment decision:
1. Payback period
2. Net present value
3. Accounting rate of return
4. Internal rate of return
 In capital investment appraisal it is more appropriate to evaluate future cash flows than
accounting profits, because:
o profits cannot be spent
o profits are subjective
o cash is required to pay dividends.
 Most methods of long term investment appraisal take into account the "time value of money".
This recognises the fact that money paid out or received now is worth more to us than the
expectation of the same amount at some future date. this is due to the following:
o Investment opportunities - money received now could be invested and hence grow to a
larger sum in the future
o Cost of finance - if business has liablity, then money received sooner could be used to repay
it and save interest.(Alternatively, payments made now might increase a loan or overdraft
resulting in higher interest payments)
o Inflation - inflation erodes the purchasing power of money. RM100 now will buy more than
RM100 in five years' time.
o Risk - future cash flows are less certain
 The implications of this can be very significant, particular for long projects.
 The time value of money is reflected in techniques such as NPV and IRR.
 The value of an investment can be viewed in two ways. It can be viewed either in terms of its value
in the future or in terms of its value in the present, as shown below.

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 RM127.63

. RM121.55

RM115.76

RM110.25

RM105.00

RM100.00

 Present value of RM1; P = RM1

(1 + r)n
 The value of P can be found in present value table as extracted below:

Year 11% 12% 13%

1 0.901 0.893 0.885
2 0.812 0.797 0.783
3 0.731 0.712 0.693
4 0.659 0.636 0.613
5 0.593 0.567 0.543
 The numbers in the table represent the present value, at the specified discount rate, of RM1
received at the end of the specified year.
 The present value is the amount that would have to be put into the bank today at the specified
interest rate in order to have accumulated RM1 at the end of the specified period.
 The present value factors decrease as the number of periods increase.
 The present value factors decrease as interest rate increases.
 Example 1
A firm is considering investing in a project that has the following cash flows:

Year (t) Expected after-tax Net Cash Flows CFt (RM)

0 (7,000)
1 2,000
2 1,000
3 5,000
4 3,000
Note:
o (RM7,000) represents the initial investment, that is required to purchase the asset.
o If the firm’s required rate of return is 15%, the cash flow time line for the asset is:

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 Payback Period
 The number of years, including the fraction of the year it takes to recapture the initial investment
 The following table shows the payback for this project

Year Cash Flows (RM) Cumulative CF

0 (7,000)
1 2,000
2 1,000
3 5,000
4 3,000
 This table shows that the payback period is between two years and three years
 The actual payback is:
Payback period = No of years before recovery + Amount of investment remaining to be paid
of original investment Total cash flow during year of payback

 As the computation shows, it takes almost three years for the firm to recapture its original
investment for this project
 The acceptance rule for payback:
Accept the project if payback, payback period < some number of years set by the firm
 This project would be acceptable if the firm wants to recapture its investments’ costs within three
years, but it would not be acceptable if the firm wants to recapture the costs within two
years
 Eventhough the concept of payback is very simple, there are problems with using payback to make
capital budgeting decisions
 The primary problem is that this technique does not use time value of money concepts—that is,
we do not compute the present values of the future cash flows
 Another problem is that the cash flows beyond the payback period are ignored. For example, if
the project described above had a RM1,000,000 cash flow in Year 4 rather than the RM3,000
originally given, the project would still have a payback equal to 2.8 years and it would not be
an acceptable project if the payback period imposed by the firm is two years.
 Advantages of using the traditional payback period:
1. Simple, easy to use
2. Cash flows are used

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 3. Provides an indication of the liquidity of a project
4. It is useful in certain situations:
o rapidly changing technology
o improving investment conditions
5. It favours quick return:
o helps company growth
o minimises risk
o maximises liquidity
6. Uses cash flows, not accounting profit.

 Disadvantages of using the traditional payback period

1. Does not use time value of money concepts
2. Ignores returns after the payback period
3. Ignores the timings of the cash flows. This can be resolved using the discounted payback
period.
4. Ignores project profitability

Net Present Value (NPV)

 To determine the NPV of a project, you need to compute the present value of all the future cash
flows associated with the project, sum them up, and then subtract (or add a negative amount to)
the initial investment of the project
 The resulting value represents the amount that the firm’s value will increase, on a present value
basis, if the firm invests in the project
 For example, if the NPV of a project is RM1,000, then the value of the firm should increase by
RM1,000 today
 Thus, a project is acceptable if its NPV is positive. If a project has a positive NPV, then it generates
a return that is greater than the cost of the funds that are used to purchase the project
 The NPV computation:

Year Cash Flows (CF) Present value factor CF x PVF

(RM) (PVF) @15%
0 (7,000)
1 2,000
2 1,000
3 5,000
4 3,000
Net present value
*Rounding error due to taking 3 PVF with decimal only
 The result of this computation is the same (slight different due to rounding error) as that given in
the cash flow time line diagram
 According to the acceptance criterion, the project should be purchased
 If the firm accepts a project with a positive NPV its value should increase, and vice versa
 Therefore, if the project had a negative NPV it would not be acceptable because such a project
would decrease the value of the firm
 Advantages of using the NPV technique:
1. Cash flows rather than profits are analyzed

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 2. Recognizes the time value of money
3. Acceptance criterion is consistent with the goal of maximizing value
4. Considers the whole life of the project
5. Should lead to maximisation of shareholder wealth.

 Disadvantage of using the NPV technique

1. Detailed, accurate long-term forecasts are required to evaluate a project’s acceptance
2. Difficult to explain to managers
3. Requires knowledge of the cost of capital
4. Relatively complex

Discounted Payback Period

 This method is used to counter the main limitation of payback period which ignore time value of
money.
 The formula to calculate discounted payback period is still the same but the discounted payback
period uses discounted cash flows instead of the original cash flows.
 Using example 1:
Year Cash Flows (CF) Present value factor CF x PVF Cumulative
(RM) (PVF) @15% discounted
cash flow
0 (7,000) 1 (7,000)
1 2,000 0.870 1,740
2 1,000 0.756 756
3 5,000 0.658 3,290
4 3,000 0.572 1,716
 The discounted payback period is:
No of years before recovery + Amount of investment remaining to be paid of original investment
Total cash flow during year of payback

Internal Rate of Return (IRR)

 It was mentioned above that a project that has a positive NPV generates a return that is greater
than the cost of the funds used to purchase the project
 The IRR is defined as the rate of return the firm would earn, on average, if it purchases the project
 To determine the IRR, we want to compute the rate of return that causes the NPV of the project
to equal zero, or where the present value of the future cash flows equals the initial investment
 If this computation seems familiar, it should be, because the computation for IRR is the same as
the computation for the yield to maturity (YTM) on bond, which was taught in basic finance
subject

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 It is not easy to solve for the IRR without a calculator because you have to use a trial-and-error
method—that is, plug in various values for IRR until the right side of the equation equals the left
side of the equation
 Interpolation formula:

Interest rate with positive Positive NPV x (Interest rate with positive
NPV + NPV -
(Positive NPV + Negative NPV) Interest rate with negative
NPV)

 Example:
Year CF PVF @15% PVF @ 20%
0 (7,000)
1 2,000
2 1,000
3 5,000
4 3,000

 Interpolation:
IRR =
=

 A project is acceptable using IRR if its IRR is greater than the firm’s required rate of return—that
is, IRR > % rate of return
 IRR represents the rate of return the firm will earn if the project is undertaken. In the example,
the project earns a return of 18.13% which is greater than the cost of the funds used to finance
the project. Therefore the project should be undertaken.
 Advantages of using the IRR technique:
1. Cash flows rather than profits are analysed
2. Recognizes the time value of money
3. Acceptance criterion is consistent with the goal of maximizing value
4. Measured in percentage and therefore easily understood
5. Considers the whole life of the project
6. Selecting projects where the IRR exceeds the cost of capital should increase shareholders'
wealth.
 Disadvantage of using the IRR technique
1. Detailed, accurate long-term forecasts are required to evaluate a project’s acceptance
2. Difficult to solve for IRR without a financial calculator or spreadsheet
3. It is fairly complicated to calculate.
4. Non-conventional cash flows may give rise to multiple IRRs which means the interpolation
method can't be used.

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 Cost of capital as a Screening Tool

• Businesses often use their cost of capital as the discount rate in capital budgeting decisions. The
cost of capital is the overall cost to the company of obtaining investment funds, including the cost
of both debt and equity sources.
• The cost of capital can be used to screen investment projects:
1. Net present value - cost of capital is used as the discount rate when computing the net
present value of a project. Any project with a negative net present value is rejected unless
there is some other overriding factor.
2. Internal rate of return - cost of capital is compared to the internal rate of return of the
project. Any project with an internal rate of return less than the cost of capital is rejected
unless there is some other overriding factor.

Comparison of the NPV and IRR Methods

 Accepting a project using the NPV technique provides the same benefit as accepting a project
using the IRR technique. As a result, both the NPV technique and the IRR technique should always
give the same accept/reject decision.
 However NPV is preferred to IRR because:
1. IRR can incorrectly rank mutually exclusive projects. Example:

IRR NPV
% RM
Project A 22 1,530
Project B 18 1,728
2. IRR is expressed in percentage terms.
Illustration 1:
Investment Y (1 year life) yields a return of 50% (I0 =100) =RM5O
Investment Z (1 year life) yields a return of 25% (I0 =RM1000) =RM250
 Y is preferable because of higher IRR of 50%. However if Y is chosen but if the remaining
RM900 can only be invested at 10% (cost of capital), hence Y only yieldsRM140 (RM50 +
RM90) then Z is preferable.
3. IRR assumes internal cash flows are reinvested at the IRR, whereas NPV assumes they are
invested at the cost of capital.
4. Unconventional cash flows (-, + -) can result in multiple rates of return

Accounting Rate of Return

 Calculate the return of an investment based on accounting profit measure.
 Formula:
Average return = Average profit___
Average investment *

* Average investment = Initial investment + Scrap value

2
 Using Example 1:
Average annual profit = [(2,000 + 1,000 + 5,000 + 3,000) – 7,000] / 4 = 1000
Average investment = (7,000 + 0) / 2 = 3,500

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 Accounting rate of return = 1000 / 3500 = 0.29 or 29%
 Decision rule: Accept project with ARR > Company’s target accounting rate of return

Single Period Capital Rationing

 Refers to a situation where investment funds are restricted and it is not possible to accept all
positive NPV projects.
 Where capital rationing exists, ranking in terms of NPVs will normally result in an incorrect
allocation of scarce capital.
 The correct approach is to rank by profitability index (Pl) = PV_______
Investment outlay
 Illustration 3:
Project Initial Ivestment PV (RM) NPV (RM) PI NPV PI Ranking
(RM) Ranking
A 25,000 32,500 7,500
B 100,000 108,250 8,250
C 50,000 75,750 25,750
D 100,000 123,500 23,500
E 125,000 133,500 8,500
F 25,000 30,000 5,000
G 50,000 59,000 9,000
Funds available for investment are restricted to RM200 000.

 NPV ranking leads to acceptance of C,D and G (NPV = C58 250)

 PI ranking leads to acceptance of C,A,D and F (NPV = C61 750)

Taxation & Investment Decisions

 Taxation legislation specifies that net cash inflows of companies are subject to taxes and capital
allowances (writing down allowances) are available on capital expenditure.

Example 2:
Cost of machine (10) = RM100,000
Cash inflows = RM50,000 for four years
Estimated sale proceeds = Tax WDV at end of year 4
Capital allowances = 25% on a reducing balance basis
Corporate tax rate = 35%
Cost of capital is estimated to be 10% per year.
Estimated realizable value/residual value at the end of the year 4 = WDV

 Calculation of capital allowances:

Year Annual Written Written-Down Value (WDV)
Down Allowance (RM) (RM)
0
1
2
3
4

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 IF Estimated sale proceeds > the WDV (i.e. 45,000 >31,640)

If company has estimated sale proceed value 45,000:

Excess allowances = 45,000 – 31,640 = 13,360 will have been claimed and this adjustment must
be made at the end of year 4. This adjustment is called a balancing charge.

Year 4
Incremental profits
Less: WDAs/CA
Taxable profits
Taxes at 35%
*If >, less: WDA =

 IF Estimated sale proceeds < WDV (i.e. 25,000 <31,640)

If company has estimated sale proceed value 25,000:

Thus, there would be an additional balancing allowance of RM6,640 (RM31,640 - RM25,000) to
add to the WDAs in year 4.

Year 4
Incremental profits
Less: WDAs/CA
Taxable profits
Taxes at 35%
Incremental profits
*If <, add: WDA =

 Calculation of taxes arising from the project:

Year 1 Year 2 Year 3 Year 4

Incremental profits
(A)
Less: WDAs/CA (B)
Taxable profits (C)
Taxes 35% (D)

 NPV calculation:
Year Cash flow (A) Taxation (B) Net cash flow Discount factor Present value
C =(A-B) (D) (E) = (C x D)
0
1
2
3
4
NPV =

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 Weighted Average Cost of Capital
 The CAPM is used to calculate the cost of equity finance.
 Most firms use a combination of debt and equity finance and both sources of finance should be
taken into account when calculating the discount rate.
 Where combinations of debt and equity are used, the WACC is used to discount project cash
flows
Example:
Cost of equity capital = 18%
Cost of debt capital = 10%
Projects financed by 50% debt and 50% equity
WACC = (0.5 x 18%)+(0.5 x 10%) = 14%

 The WACC represents the firm 's overall cost of capital based on the average risk of all the firm
's projects. If the risk of a project differs from average firm risk the WACC of the firm will not
reflect the correct risk-adjusted discount rate.

Sensitivity Analysis
 Shows how sensitive NPV is to a change in the assumptions relating to the variables used to
compute it (e.g. pessimistic, most likely or optimistic estimates). Can also be used to indicate the
extent to which variables may change before NPV becomes negative.
Example:
Year Year Year
I (RM) 2 (RM) 3 (RM)
Cash inflows (10 000 x RM30) 300000 300000 300000
VC 200000 200000 200000
Net cash flows 100000 100000 100000

10 = RM200000 cost of capital = 1 5%, NPV = RM28300

 Sales volume
- NPV =0 when net cash flows are RM87600 (RM200000 / 2.283)
- Total net cash flows can decline by RM12400 p.a. before NPV becomes negative
- Total sales can fall by RM37200 p.a. (i.e. l 2.4%) or 1240 units
 Note net cash flows are one-third of sales

 Selling price
- Total sales revenue can fall to RM287600 (RM300000 - RM12400) before NPV becomes
negative =RM28.76 per unit (i.e.4.1% decline)
 Variable costs
- Can increase by RM12400 p.a. (RM1.24 per unit) = 6.2% decline.
 Initial outlay
- Can increase by RM28300 (14.15%)
 Cost of capital
- IRR = 23% (cost of capital can increase by 53%)
 Highlights those variables that are most sensitive so that their estimates can be thoroughly
reviewed.

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 Limitations
- Considers variables in isolation
- Ignores probabilities

Tutorial Questions

IM13.2, IM14.2.

Question 1
Your company is considering investing in its own transportation. The present position is that carriage
is contracted to an outside organization. The life of the transportation would be five years, after
which time the vehicles would have to be disposed of. The cost to your company of using the outside
organization as follows:
Year 1 RM250,000
Year 2 275,000
Year 3 302,500
Year 4 332,750
Year 5 366,025

The initial cost of the transportation would be RM750 000 and it is estimated that the following costs
would be incurred over the next five years:

Driver costs (RM) Repairs & maintenance (RM) Miscellaneous (RM)

Year 1 33,000 8,000 130,000
Year 2 35,000 13,000 135,000
Year 3 36,000 15,000 140,000
Year 4 38,000 16,000 136,000
Year 5 40,000 18,000 142,000

Miscellaneous costs include depreciation. It is projected that the transportation would be sold for
RM150,000 at the beginning of year 6. It has been agreed to depreciate the transportation on a
straight line basis. To raise funds for the project your company is proposing to raise a long-term loan
at 12% interest rate per annum. You are told that there is an alternative project that could be invested
in using the funds raised which has the following projected results:
Payback = 3 years
Accounting rate of return = 30%
Net present value = RM140 000.

As funds are limited, investment can only be made in one project.

Required:

(a) Prepare a table showing the net cash savings to be made by the firm over the life of the
transportation project.

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(b) Calculate the following for the transportation project:
(i) Payback period
(ii) Accounting rate of return
(iii) Net present value
(c) Write a short report to the Investment Manager in your company outlining whether
investment should be committed to the transportation project or the alternative project
outlined. Clearly state the reasons for your decision

Question 2
Azada Sdn. Bhd. (ASB) operates in Pasir Gudang, Johor where investments in plant and machinery
are eligible for 20% initial allowance and 14% annual allowance. The corporate tax is 25% and is
payable one year in arrears. ASB is considering whether to purchase some machinery which will cost
RM1 million and which is expected to result in additional net cash inflows and profits as follows:

Year 1 Year 2 Year 3 Year 4

(RM) (RM) (RM) (RM)
Cash inflows & profits 500,000 550,000 500,000 550,000

It is anticipated that the machinery will be sold at the beginning of Year 5 with residual value of
RM250,000. The company’s cost of capital is estimated to be 10% per year.

Required:

(a) Compute four years capital allowance for the machinery.

(b) Calculate additional taxable profit arising from the project for each year. (Show all relevant
workings, round up your answer to zero decimal points.)

(c) Calculate the net present value (NPV) for the proposed machinery.

(d) Explain the difference between the following two capital budgeting projects and provide ONE
(1) example for each:
(i) Independent project
(ii) Mutually exclusive project

Question 3
Haziq is the chief accountant for Bidara Engineering Bhd, one of the largest manufacturing companies
in Malaysia. He is currently facing a situation where he has to make a decision whether to invest in a
project manufacturing a new product. The product has a very short life cycle. His assistant has already
prepared the following cost projections for year 1:

Cost per unit RM

Direct material 10.00
Direct labour 8.50
Variable overhead 2.00
Fixed overhead (allocated) 1.50

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The selling price per unit is RM30 and expected to increase by 6% per annum. It is projected that
250,000 units will be sold in year 1 , 270,000 units in year 2 and 300,000 units in year 3. The direct
material cost is expected to increase by 5% per annum. Direct labour and variable overhead will
increase by 3% per annum.

The initial investment for the project is RM3 million for the purchased of a special machine from
Germany. The machine scrap value at the end of the project life is RM500,000. The machine will be
sold at the beginning of Year 4. The company is entitled to 20% initial allowance and 20% annual
allowance on the purchase of the machine.

Bidara Engineering Bhd cost of capital is 12% per annum.

The company corporation tax is 25% and tax is payable in the year it occurs.

Required:
(a) Calculate the net present value and discounted payback period of the project.
(b) Explain the advantages and disadvantages of using payback period as a method of capital
investment appraisal.

Question 4
Singa Holding is considering an expansion of its product line. The proposed expansion plan would
require acquisition of new plant and equipment costing RM800,000. The plant and equipment have
an estimated useful life of 3 years and is expected to be sold for RM200,000 at the beginning of Year
4. It is eligible for a 20% initial capital allowance and 14% annual capital allowance on a straight line
basis. Singa Holding depreciates the plant and equipment on a straight line basis in its books of
accounts.

The costs and revenue information relating to the new product in year 1 are given below:
Selling price per unit RM15
Variable cost per unit RM6
Additional fixed costs RM250,000 per annum.
Additional fixed costs include the straight line depreciation on the new plant and equipment.

The company estimated that the units produced and sold are as follows:
Year 1 85,000 units
Year 2 90,000 units
Year 3 100,000 units
The selling price per unit is expected to increase by 4% each year and variable cost increasing by 2%
per year.

One third of the expansion plan will be financed by internal fund and the remaining from a bank loan
with an interest rate of 12%. The company cost of capital is 15%.

Singa Holding is subject to 25% tax rate and taxes are paid one year in arrears.

The company normally uses payback period calculation to screen its projects and would reject new
investment with a payback period of more than 2 years.

Page 16 of 24
Required:

(a) Evaluate whether the proposed investment plan should be undertaken by calculating the net
present value and payback period.

(b) Payback period is easy to understand, however it does not take into consideration the effect
of time value of money in capital investment appraisal. Explain one other limitation of
payback and three other advantages.

Question 5
Astana Factory Sdn. Bhd. (AFSB) manufactures industrial and residential fixtures. AFSB is considering
introducing a new innovative product called Power Light. This propose project will require AFSB to
acquire a special equipment which cost at RM95,000 with three years estimated useful life and
RM15,000 residual value at end of Year 3. However the equipment will be sold at the beginning of
Year 4. This equipment qualifies for 20% initial capital allowance and 14% annual capital allowance
on a straight line basis.. The production manager, Encik Ammar has prepared the following
information for this propose project:

Year 1 2 3
RM RM RM
Sales 58,700 75,500 80,650
Direct Materials 10,400 11,000 12,400
Direct labour 2,100 3,000 4,900
Direct overheads 250 415 550

AFSB is subjects to 25% tax rate and tax is payable in the year it’s occur. The company’s cost of capital
is estimated to be 12% per year. It is assumed that the initial capital investment will be incurred at
the beginning of the first year and all other receipts and payments will occur at the end of each year.

Required:
(a) Compute the three years capital allowance qualified for the special equipment in each year.
(b) Prepare a three-year statement which includes the taxable profit and tax payable for each
year. (Show all relevant workings.)
(c) Calculate the net present value (NPV) for the propose project.

Question 6
JK offers an automotive parts replacement service in over 500 depots throughout the country. JK’s
current service involves customers driving to the company’s depots where they can get immediate
replacement of tyres, exhausts and other automotive parts.

The company is considering the introduction of a mobile tyre fitting service whereby a JK van will visit
the customer and fit the new tyres. The project will require the purchase of 200 vans to enable
nationwide coverage. The fleet of vans will cost a total of RM24 million to purchase and fit out with
the required equipment. The vans are expected to have a useful life of 4 years at the end of which
they will be sold for cash of RM2 million in total. The disposal of the vans will take place at the
beginning of Year 5.

Page 17 of 24
Revenue and contribution
The mobile service will be available 12 hours per day for 360 days of the year. Each tyre replacement
call out is expected to last for 1½ hours including travel time between locations. The vans are not
expected to be utilised for 100% of the time but the percentage utilisation is expected to increase
over the period of the project. The expected percentage utilisation of the vans is given below:

Year Van utilisation

1 70%
2 80%
3 90%
4 90%

The expected value of the charge to the customer will be RM180 per call out. The expected value of
the variable cost, including fuel costs, will be RM120 per call out. It is estimated that 30% of the
customers using the mobile fitting service would have otherwise travelled to the company’s depots
to have their tyres fitted. The company’s depots have sufficient available capacity to provide a service
to these customers. The contribution per customer in the company’s depots is RM100.

Fixed costs
The only incremental fixed costs associated with this project relate to the vans and the equipment.
The total annual maintenance costs for the 200 vans are expected to be RM0.5 million. Other fixed
operating costs, including depreciation of the vans and the equipment, will be a total of RM8 million
per annum. Depreciation will be calculated using the straight line method.

Taxation
The company’s financial director has provided the following taxation information:
• Tax depreciation: 20% initial capital allowance and 20% annual capital allowance on a straight line
basis.
• Taxation rate: 30% of taxable profits. Half of the tax is payable in the year in which it arises, the
balance is paid in the following year.

Other information
The company uses a cost of capital of 12% per annum to evaluate projects of this type.
Ignore inflation.

Required:
(a) Evaluate the project using net present value and discounted payback period. Your workings
should be shown in RM million.

(b) Explain how sensitivity analysis techniques could be used to assess the risk of the project
evaluated in part (a).

Page 18 of 24
Question 7
IK Contractor Sdn Bhd (IKC), a civil engineering contractor, is considering launching a new product
line called Vass. The proposed plan would require acquisition of new plant and equipment costing
RM750,000. The plant and equipment have an estimated useful life of 4 years and is expected to be
sold at RM150,000 at the beginning of year 5. It is eligible for a 30% per annum initial allowance and
a 10% per annum annual allowance for tax purposes. IKC depreciates its plant and equipment on a
straight line basis in its books of accounts.

The costs and revenue information relating to the new product in year 1 are given below:

Selling price per unit RM30

Direct Materials per unit RM10
Direct Labour per unit RM8

The company estimated that the units produced and sold are as follows:
Year 1 25,000 units
Year 2 40,000 units
Year 3 65,000 units
Year 4 75,000 units
The selling price per unit of Vass is expected to increase by 5% each year and all direct costs increasing
by 4% per year.

IKC is subject to 26% tax rate and taxes are paid one year in arrears. The weighted average cost of
capital is 14% per year.

The company normally uses payback period calculation to screen its projects and would reject new
investment with a payback period of more than 2 years.

Required:

a) Evaluate whether the proposed investment plan should be undertaken by calculating the net
present value and payback period.

b) Based on your answer in (a) above, advice IKC on the purchase of the new plant and
equipment. Your answer should include reasons for decision.

Page 19 of 24
Question 8
Frozen Berhad produces computer components. It is considering introducing a new product. The
projections for this proposal are as follows:

Year
1 2 3
(RM000) (RM000) (RM000)
Sales 8,750 12 ,250 13,300
Direct materials 1,340 1,875 2,250
Direct labour 2,675 3,750 4,500
Direct overheads 185 250 250
Depreciation 2,500 2,500 2,500
Interest 1,012 1,012 1,012
Profit before tax 1,038 2,863 2,788
Corporate tax @ 28% 291 802 781
Profit after tax 747 2,061 2,007

Additional information:
1. The initial capital investment and additional working capital will be incurred at the beginning of the
first year. All other receipts and payments will occur at the end of each year;
2. The equipment will cost RM10 million with no scrap value at the end of the three-year period. It
qualifies for an initial allowance of 20% and an annual allowance of 20% per annum on straight
line basis. Any outstanding capital allowances at the end of the project can be claimed as
balancing allowance.
3. The additional working capital of RM1 million recovered in full as cash at the end of the three-
year period; and does not qualify for capital allowances, nor is it an allowable expense in
calculating taxable profit;
4. Frozen Berhad pays corporation tax at 28% of chargeable profits;
5. There is a one-year delay in paying tax;
6. The company’s cost of capital is 17%.
7. The company’s policy is to reject the project if it takes more than 3 years to recoup the amount
invested.

Required:
a) Evaluate the project using net present value technique.
b) Calculate the payback period of the project.
c) Recommend whether the project is worthwhile based on your calculations in (a) and (b); provide
justification for your answer.
d) Explain the advantages and disadvantages of the investment appraisal method using net
present value (NPV)
(Note: Ignore risk and inflation.)

Page 20 of 24
Question 9
Enviro Tech Bhd (ETB) plans to replace an assembly machine. The replacement machine will cost
RM1,000,000, which is payable on 1 January 2018. The machine will be used for 4 years and the scrap
value at the end of its useful life is RM50,000. The machine will be sold at the beginning of the fifth
year. The company is entitled to 20% initial allowance and 14% annual allowance on the purchase of
the machine. The new machine will be able to assemble 24,000 units a year. However, this is expected
to rise by 25% from the start of the third year.
1. It is assumed that all units produced are sold.
2. Each unit of production costs RM25 to manufacture, but will rise to RM27 in year 3 and RM28
in year 4. These production costs include depreciation of the new assembly machine.
3. Each unit is expected to sell for RM35 in Year 1 and will rise by 10% in Year 2. Thereafter
remaining constant as in Year 2.
4. Corporation tax is 24% of taxable profit. The company pays tax one year in arrears.
5. The cost of capital is 10%.

Required:

(a) Calculate the net present value of the project. Show all workings.

(b) Based on your answer in (a) above, explain whether ETB should go ahead with the proposal
to replace the assembly machine.

(c) Explain ONE (1) advantage and ONE (1) disadvantage of the investment appraisal method
using net present value (NPV).

Question 10
Entel Corporation, a semiconductor firm, is considering investing in the production of mini personal
computers, NMOS, using hybrid memory technology. Entel’s targeted market for this computer will
be senior business and IT decision makers.

The company has already spent RM750,000 in developing NMOS but will require a further investment
of RM7.09 million in a new manufacturing facility at the beginning of Year 1. This facility would have
a useful life of three years and could be sold for cash of RM1.36 million at the beginning of the fourth
year. The manufacturing facility will be depreciated over three years using the straight-line method.
The company is entitled to 20% initial allowance and 14% annual allowance on this facility.

The sales and production of the NMOS over its life cycle (Year 1 to Year 3) are projected to be 42,000
units, 59,000 units and 75,000 units respectively. It is assumed that all units produced are sold. The
selling price in Year 1 will be RM1,500 per unit and the variable cost per unit will be RM690. NMOS
will be exclusively produced in the new manufacturing facility. The total fixed costs in Year 1 will be
RM4.5 million including depreciation. The selling price, variable cost per unit and fixed costs are
expected to increase by 4% each year. Entel Corporation pays tax of 24% one year in arrears. The
company’s cost of capital is estimated to be 12% per year. It is assumed that the initial capital
investment will be incurred at the beginning of the first year.

Required:
(a) Calculate the net present value (NPV) of the project. Show all workings.
[15 marks]

Page 21 of 24
(b) Based on your answer in (a) above, explain whether Entel Corporation should proceed with
the proposal to invest in the production of mini personal computers.
[2 marks]

(c) Explain THERE (3) advantages of NPV as the investment appraisal method.
[3 marks]
Question 11
Peperoci Sdn. Bhd. (PSB) is considering an expansion of its product line. The proposed expansion plan
would require the acquisition of a new plant and equipment costing RM700,000. The plant and
equipment has an estimated useful life of 3 years and is expected to be sold at RM100,000 at the
end of year 3. It is eligible for a 20% initial capital allowance and 14% annual capital allowance on a
straight line basis. PSB depreciates the plant and equipment on a straight-line basis in its books of
accounts. The company estimated that the units produced and sold are as follows:

Year Units produced and sold

1 90,000
2 95,000
3 100,000

The selling price per unit is expected to increase by 5% each year and variable cost to increase by 3%
per year. The costs and revenue information relating to the new product in year 1 are given below:
RM
Selling price per unit 16.00
Variable cost per unit 8.00
Additional fixed costs 280,000

Additional fixed costs include the depreciation on the new plant and equipment. The company’s cost
of capital is 12%. PSB is subject to 24% tax rate and taxes are paid one year in arrears.

The company normally uses payback period calculation to screen its projects and would reject new
investment with a payback period of more than 2 years.

Required:
(a) Calculate the net present value of the proposed investment.
[12 marks]
(b) Calculate the payback period of the project.
[2 marks]

(c) Recommend whether the project is worthwhile based on your calculations in (a) and (b)
above. Provide justification for your answer.
[2 marks]
(d) Explain FOUR (4) advantages and FOUR (4) disadvantages of payback period.
[4 marks]

Page 22 of 24
 Appendix 1: Present Value Table

Present value interest factor of RM1 per period at i% for n periods, PVIF(i,n).
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Period
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 16
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 17
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 18
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 19
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149 20

Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% Period
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054 16
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045 17
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038 18
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031 19
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026 20
Appendix 2: Annuity Table

Page 23 of 24
 Present value interest factor of an (ordinary) annuity of RM1 per period at i% for n periods, PVIFA(i,n).
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Period
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 15
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 16
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 17
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 18
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 19
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514 20

Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% Period
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 16
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 17
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 18
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 19
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870 20

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