REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)

Project 2

Ridag Co plans to replace an existing machine and must choose between two machines. Machine 1 has
an initial cost of $200,000 and will have a scrap value of $25,000 after four years. Machine 2 has an
initial cost of $225,000 and will have a scrap value of $50,000 after three years. Annual maintenance
costs of the two machines are as follows:

Year 1 2 3 4
Machine 1 ($/year) 25,000 29,000 32,000 35,000
Machine 2 ($/year) 15,000 20,000 25,000

Where relevant, all information relating to Project 2 has already been adjusted to include expected
future inflation. Taxation and tax-allowable depreciation must be ignored in relation to Machine 1 and
Machine 2.

Other information

Ridag Co has a nominal before-tax weighted average cost of capital of 12% and a nominal after-tax
weighted average cost of capital of 7%.

Required:

(a) Calculate the net present value of Project 1 and comment on whether this project is
financially acceptable to Ridag Co. (10 marks)

(b) Calculate the equivalent annual costs of Machine 1 and Machine 2, and discuss which
machine should be purchased. (5 marks)

(15 marks)

Question 18 BQK CO

BQK Co, a house-building company, plans to build 100 houses on a development site over the next four
years. The purchase cost of the development site is $4,000,000, payable at the start of the first year of
construction. Two types of house will be built, with annual sales of each house expected to be as
follows:

Year 1 2 3 4
Number of small houses sold: 15 20 15 5
Number of large houses sold: 7 8 15 15

Houses are built in the year of sale. Financial information relating to each type of house is as follows:

Small house Large house

Selling price: $200,000 $350,000
Variable cost of construction: $100,000 $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 $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.

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FINANCIAL MANAGEMENT (F9) – REVISION QUESTION BANK

BQK Co pays profit tax one year in arrears at an annual rate of 30%. The company can claim tax-
allowable depreciation on the purchase cost of the development site on a straight-line basis over the
four years of construction.

BQK 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.

New investments are required by the company to have a before-tax return on capital employed
(accounting rate of return) on an average investment basis of 20% per year.

Required:

(a) Calculate the net present value of the proposed investment and comment on its financial
acceptability. Work to the nearest $1,000. (11 marks)

(b) Calculate the before-tax return on capital employed (accounting rate of return) of the
proposed investment on an average investment basis and discuss briefly its financial
acceptability. (4 marks)

(15 marks)

Question 19 HDW CO

HDW Co is a listed company which plans to meet increased demand for its products by buying new
machinery costing $5 million. The machinery would last for four years, at the end of which it would be
replaced. The scrap value of the machinery is expected to be 5% of the initial cost. Tax-allowable
depreciation would be available on the cost of the machinery on a 25% reducing balance basis, with a
balancing allowance or charge claimed in the final year of operation.

This investment will increase production capacity by 9,000 units per year and all of these units are
expected to be sold as they are produced. Relevant financial information in current price terms is as
follows:

Forecast inflation
Selling price $650 per unit 4·0% per year
Variable cost $250 per unit 5·5% per year
Incremental fixed costs $250,000 per year 5·0% per year

In addition to the initial cost of the new machinery, initial investment in working capital of $500,000
will be required. Investment in working capital will be subject to the general rate of inflation, which is
expected to be 4·7% per year.

HDW Co pays tax on profits at the rate of 20% per year, one year in arrears. The company has a
nominal (money terms) after-tax cost of capital of 12% per year.

Required:

(a) Calculate the net present value of the planned purchase of the new machinery using a
nominal (money terms) approach and comment on its financial acceptability. (11 marks)

(b) Discuss the difference between a nominal (money terms) approach and a real terms
approach to calculating net present value. (4 marks)

(15 marks)

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 REVISION QUESTION BANK – FINANCIAL MANAGEMENT (F9)

Question 20 DARN CO

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

Year 1 2 3 4
Sales revenue ($000) 1,250 2,570 6,890 4,530
Costs ($000) 500 1,000 2,500 1,750

These forecast cash flows are before taking account of general inflation of 4·7% per year. The capital
cost of the investment project, payable at the start of the first year, will be $2,000,000. The investment
project will have zero scrap value at the end of the fourth year. The level of working capital investment
at the start of each year is expected to be 10% of the sales revenue in that year.

Tax-allowable depreciation would be available on the capital cost of the investment project on a 25%
reducing balance basis. Darn Co pays tax on profits at an annual rate of 30% per year, with tax being
paid one year in arrears. Darn Co has a nominal (money terms) after-tax cost of capital of 12% per
year.

Required:

(a) Calculate the net present value of the investment project in nominal terms and comment
on its financial acceptability. (10 marks)

(b) Calculate the net present value of the investment project in real terms and comment on
its financial acceptability. (5 marks)

(15 marks)

Question 21 REPLACEMENT CYCLES

(a) Discuss the problems faced when undertaking investment appraisal in the following
areas and comment on how these problems can be overcome:

(i) assets with replacement cycles of different lengths;

(ii) an investment project has several internal rates of return;

(iii) the business risk of an investment project is significantly different from the
business risk of current operations. (8 marks)

(b) A company with a cost of capital of 14% is trying to determine the optimal replacement cycle
for the notebook computers used by its sales team. The following information is relevant to
the decision:

The cost of each notebook is $2,400. Maintenance costs are payable at the end of each full
year of ownership, but not in the year of replacement (e.g. if the notebook is owned for three
years, then the maintenance cost is payable at the end of year 1 and at the end of year 2).

Interval between Trade-in Value ($) Maintenance cost ($)

Replacement (years)
1 1200 Zero
2 800 75 (payable at end of Year 1)
3 300 150 (payable at end of Year 2)

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