PFM 4-2

The following scenario relates to questions 144–148.

 Joy Co

The following information relates to an investment project which is being evaluated by the directors of Joy Co, a listed company. The initial investment, payable at the start of the first year of operation, is $3.9 million.

The directors believe that this investment project will increase shareholder wealth if it achieves a return on capital employed greater than 15%. As a matter of policy, the directors require all investment projects to be evaluated using both the payback and return on capital employed methods. Shareholders have recently criticised the directors for using these investment appraisal methods, claiming that Joy Co ought to be using the academically-preferred net present value method.

The directors have a remuneration package which includes a financial reward for achieving an annual return on capital employed greater than 15%. The remuneration package does not include a share option scheme.

149. What is the payback period of the investment project?

150. Based on the average investment method, what is the percentage return on capital employed of the investment project, to one decimal place?

151. Which TWO of the following statements about investment appraisal methods are correct?

152. Which of the following statements about Joy Co is/are correct?

153. Which of the following statements about Joy Co directors’ remuneration package is/are correct?

1. Directors’ remuneration should be determined by senior executive directors.
2. Introducing a share option scheme would help bring directors’ objectives in line with shareholders’ objectives.
3. Linking financial rewards to a target return on capital employed will encourage short-term profitability and discourage capital investment.

The following scenario relates to questions 149–153.

Shades Co.

Shades Co. is considering a project with the following cash flows.

Year Initial investment Variable costs Cash inflows Net cash flows

$’000 $’000 $’000 $’000

0 (11,000) (11,000)

1 (3,200) 10,300 7,100

2 (3,200) 10,300 7,100

Cash flows arise from selling 1,030,000 units at $10 per unit. The company has a cost of capital of 9%.

The net present value (NPV) of the project is $1,490.

154. What is the discounted payback of the project?

155. What is the internal rate of return (IRR) of the project (using discount rates of 15% and 20%)?

156. Which TWO of the following statements are true of the IRR and the NPV methods of appraisal?

157. What is the sensitivity of the project to changes in sales volume (to one decimal place)?

158. Which of the following statements is/are true?

A. Using random numbers to generate possible values of project variables, a simulation model can generate a standard deviation of expected project outcomes.

B. The problem with risk and uncertainty in investment appraisal is that neither can be quantified or measured.

C. The sensitivity of NPV to a change in sales volume can be calculated as NPV divided by the present value of future sales income.

D. The certainty equivalent approach converts risky cash flows into riskless equivalent amounts which are discounted by a capital asset pricing model (CAPM) derived project-specific cost of capital.

The following scenario relates to questions 149–153.

 Costa Co

Costa Co needs to replace a major piece of office equipment that is in constant use and for which there is expected to continue to be use for the foreseeable future. Two types of machine are available with different capital costs, useful lives, scrap values and annual running costs.

Machine 1 will initially cost $480,000, have a life of four years, scrap value of $60,000 and annual running costs of $72,000.

Machine 2 will initially cost $540,000, have a life of three years, scrap value of $120,000 and annual running costs of $47,000.

Costa Co’s cost of capital is 10%. Assume all cash flows, except the initial capital cost, occur at the end of the relevant year and assume that taxation and inflation can be ignored.

159. What is the equivalent annual cost of machine 2 (to the nearest $000)?

160. Drag and drop the relevant statements to indicate whether they are true or false.

(1) The equivalent annual cost calculation assumes the same type of machine is going to be used into the foreseeable future.

(2) The equivalent annual cost calculation assumes the capabilities of Machine 1 and Machine 2 are identical.

161. It is now felt that the final scrap value of the machines depends on two factors: whether or not a new supplier enters the market (which would reduce the likely scrap value) and the strength of the dollar against other currencies (since sales of used machines will be made abroad and invoiced in the foreign currency). Adverse effects will each reduce the scrap value by 10% of the figure used in the investment appraisal. The relevant probabilities are as follows.

New supplier       Probability       Strong $        Probability

Yes                    0.4                 Yes                  0.3

No                    0.6                  No                   0.7

What is now the expected value of the scrap proceeds from machine 2?

162. To overcome the difficulties of incorporating probabilities into the investment appraisal calculations, Costa Co could perform a simulation exercise to help reach a decision. Indicate which of the following statements, relating to simulation, is/are

163. Which of the following statements about Costa Co’s replacement decision are true?

1) The decision between machine 1 and machine 2 could be found by calculating total NPV of each machine over a 12 year period.

2) The replacement analysis model assumes that Costa Co replaces like with like each time it needs to replace an existing asset.

BRT Co (6/11, amended)

The following scenario relates to questions 159–163.

BRT Co has developed a new confectionery line that can be sold for $5.00 per box and that is expected to have continuing popularity for many years. The finance director has proposed that investment in the new product should be evaluated over a four-year time-horizon, even though sales would continue after the fourth year, on the grounds that cash flows after four years are too uncertain to be included.

The variable cost (in current price terms) will depend on sales volume, as follows.

Sales volume (boxes) Less than 1 million 1–1.9 million 2–2.9 million 3–3.9 million

Variable cost ($ per box) 2.80 3.00 3.00 3.05

Forecast sales volumes are as follows.

Year 1 2 3 4

Demand (boxes) 0.7 million 1.6 million 2.1 million 3.0 million

Tax

Tax-allowable depreciation on a 25% reducing balance basis could be claimed on the cost of equipment. Profit tax of 30% per year will be payable one year in arrears. A balancing allowance would be claimed in the fourth year of operation.

Inflation

The average general level of inflation is expected to be 3% per year for the selling price and variable costs. BRT Co uses a nominal after-tax cost of capital of 12% to appraise new investment projects.

A trainee accountant at BRT Co has started a spreadsheet to calculate the net present value (NPV) of a proposed new project.

164. What is the sales figure for Year 2 (cell D3 in the spreadsheet), to the nearest $’000? $

164. What are the variable costs for Year 3 (cell E4 in the spreadsheet), to the nearest $’000? $

166. What are the tax benefits generated by the tax-allowable depreciation on the equipment in Year 4 (cell F8), to the nearest $’000? $

167. Which of the following statements about the project appraisal are true/false?

A. The trainee accountant has used the wrong percentage for the cost of capital.

B. Ignoring sales after four years underestimates the value of the project.

C. The working capital figure in Year 4 is wrong.

168. The trainee accountant at BRT Co has calculated the internal rate of return (IRR) for the project. Are the following statements true or false?

1 When cash flow patterns are conventional, the NPV and IRR methods will give the same    accept or reject decision.

The project is financially viable under IRR if it exceeds the cost of capital.

Builder Co

The following scenario relates to questions 169-173.

Builder Co is appraising four different projects but is experiencing capital rationing in Year 0. No capital rationing is expected in future periods but none of the four projects that Builder Co is considering can be postponed, so a decision must be made now. Builder Co’s cost of capital is 12%.

The following information is available.

169. Arrange the projects in order of their preference to Builder using the profitability index, with the most attractive first.

170. Which of the following statements about Builder Co’s decision to use PI is true?

171. Several years later, there is no capital rationing and Builder Co decides to replace an existing machine. Builder Co has the choice of either a Super machine (lasting four years) or a Great machine (lasting three years).

The following present value table includes the figures for a Super machine.

Tax and tax-allowable depreciation should be ignored.

What is the equivalent annual cost (EAC) of the Super machine (to the nearest whole number)?

172. Which of the following statements concerning Builder Co’s use of the EAC are true?

1 The use of equivalent annual cost is appropriate in periods of high inflation.

2 The EAC method assumes that the machine can be replaced by exactly the same machine in perpetuity.

173. The following potential cash flows are predicted for maintenance costs for the Great machine:

Year             Cash flow        Probability $

2                 19,000                0.55

2                 26,000                0.45

3                 21,000                0.3

3                 25,000                0.25

3                 31,000                0.45

What is the expected present value of the maintenance costs for Year 2 (to the nearest whole number)?