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)?

Easter Co

The following scenario relates to questions 174-178.

Easter Co is about to hold its annual strategic planning meeting and a number of capital investment projects will be discussed. A summary of the projects’ cash flows is shown below.

The investment will need to be made at the start of the coming year; no projects can be delayed and none are divisible. The funds available for these projects are limited to $10,000,000.

174. Indicate, whether the following statements about capital rationing are true or false.

A. Both hard and soft capital rationing are the result of external factors

B. Soft rationing is the result of external factors, hard rationing is the result of internal policies

C. Hard rationing is the result of external factors, soft rationing is the result of internal policies

D. Both hard and soft capital rationing are the result of internal policies

175. From the list below, select which TWO projects should be accepted, based on the circumstances described?

176. What projects would be accepted if it was found that projects A and E were mutually exclusive?

177. What projects, and fractions of projects, would be accepted if a partner could be found to invest in a proportion of one of the projects making them effectively infinitely divisible (ignoring the mutually exclusive limitation)?

178. A sixth project, Project F, is causing considerable confusion, particularly among those members of the board of Easter Co whose sole means of appraising projects is to find an internal rate of return (IRR) using the spreadsheet function on their computers. The summarised cash flows of Project F are as follows.

Time 0      Invest     $4.00m

Time 1    Receive    $8.80m

Time 2     Spend      $4.83m

The spreadsheet function requires you to enter the cash flows of a project and also enter a guess for the IRR. The directors are struggling to guess the IRR for this sixth project.

What is the likely cause of the confusion over project F?

Trecor Co (Specimen exam 2007, amended)

The following scenario relates to questions 179–184.

Trecor Co plans to buy a machine costing $250,000 which will last for 4 years and then be sold for $5,000. Net cash flows before tax are expected to be as follows.

Depreciation is charged on a straight-line basis over the life of an asset.

176. Calculate the before-tax return on capital employed (accounting rate of return) based on the average investment (to the nearest whole percentage). %

180. Are the following statements on return on capital employed (ROCE) true or false?

A. ROCE can be used to compare two mutually exclusive projects.

B. If ROCE is less than the target ROCE then the purchase of the machine can be recommended.

181. Trecor Co can claim tax-allowable depreciation on a 25% reducing balance basis. It pays tax at an annual rate of 30% one year in arrears. What amount of tax relief would be received by Trecor in time 4 of a net present value (NPV) calculation? $

182. What is the payback period for the machine (to the nearest whole month)?

A. Years

B. Months

183. Which TWO of the following statements about the internal rate of return (IRR) are TRUE?

184. Pinks Co (Mar/Jun 2019)

Pinks Co is a large company listed on a major stock exchange. In recent years, the board of Pinks Co has been criticised for weak corporate governance and two of the company’s non-executive directors have just resigned. A recent story in the financial media has criticised the performance of Pinks Co and claims that the company is failing to satisfy the objectives of its key stakeholders.

Pinks Co is appraising an investment project which it hopes will boost its performance. The project will cost $20 million, payable in full at the start of the first year of operation. The project life is expected to be four years. Forecast sales volumes, selling price, variable cost and fixed costs are as follows:

Selling price and cost information are in current price terms, before applying selling price inflation of 5% per year, variable cost inflation of 3.5% per year and fixed cost inflation of 6% per year.

Pinks Co pays corporation tax of 26%, with the tax liability being settled in the year in which it arises. The company can claim tax-allowable depreciation on the full initial investment of $20 million on a 25% reducing balance basis. The investment project is expected to have zero residual value at the end of four years.

Pinks Co has a nominal after-tax cost of capital of 12% and a real after-tax cost of capital of 8%. The general rate of inflation is expected to be 3.7% per year for the foreseeable future.

Required

A. (i) Calculate the nominal net present value of Pinks Co’s investment project.

(ii) Calculate the real net present value of Pinks Co’s investment project and comment on your findings.

B. Discuss FOUR ways to encourage managers to achieve stakeholder objectives.

185. Copper Co (Mar/Jun 18)

Copper Co is concerned about the risk associated with a proposed investment and is looking for ways to incorporate risk into its investment appraisal process. The company has heard that probability analysis may be useful in this respect and so the following information relating to the proposed investment has been prepared:

However, the company is not sure how to interpret the results of an investment appraisal based on probability analysis.

The proposed investment will cost $3.5m, payable in full at the start of the first year of operation. Copper Co uses a discount rate of 12% in investment appraisal.

Required

(a) Using a joint probability table:

(i) Calculate the mean (expected) NPV of the proposed investment.

(ii) Calculate the probability of the investment having a negative NPV.

(iii) Calculate the NPV of the most likely outcome.

(iv) Comment on the financial acceptability of the proposed investment.

B. Discuss TWO of the following methods of adjusting for risk and uncertainty in investment appraisal:

(i) Simulation

(ii) Adjusted payback

(iii) Risk-adjusted discount rates

186. VYXYN Co (Mar/Jun 17)

Vyxyn Co is evaluating a planned investment in a new product costing $20m, payable at the start of the first year of operation. The product will be produced for four years, at the end of which production will cease. The investment project will have a terminal value of zero. Financial information relating to the investment project is as follows:

These selling prices have not yet been adjusted for selling price inflation, which is expected to be 3.5% per year. The annual fixed costs are given above in nominal terms.

Variable cost per unit depends on whether competition is maintained between key suppliers of components. The purchasing department has made the following forecast:

The variable costs in this forecast are before taking account of variable cost inflation of 4.0% per year.

Vyxyn Co can claim tax-allowable depreciation on a 25% per year reducing balance basis on the full investment cost of $20m and pays corporation tax of 28% one year in arrears.

It is planned to finance the investment project with an issue of 8% loan notes, redeemable in ten years’ time. Vyxyn Co has a nominal after-tax weighted average cost of capital of 10%, a real after-tax weighted average cost of capital of 7% and a cost of equity of 11%.

Required:

(a) Discuss the difference between risk and uncertainty in relation to investment appraisal.

B. Calculate the expected net present value of the investment project and comment on its financial acceptability and on the risk relating to variable cost.

C. Critically discuss how risk can be considered in the investment appraisal process.

187. Hebac Co (Sep 16)

Hebac Co is preparing to launch a new product in a new market which is outside its current business operations. The company has undertaken market research and test marketing at a cost of $500,000, as a result of which it expects the new product to be successful. Hebac Co plans to charge a lower selling price initially and then increase the selling price on the assumption that the new product will establish itself in the new market. Forecast sales volumes, selling prices and variable costs are as follows:

Selling price and variable cost are given here in current price terms before taking account of forecast selling price inflation of 4% per year and variable cost inflation of 5% per year.

Incremental fixed costs of $500,000 per year in current price terms would arise as a result of producing the new product. Fixed cost inflation of 8% per year is expected.

The initial investment cost of production equipment for the new product will be $2.5 million, payable at the start of the first year of operation. Production will cease at the end of four years because the new product is expected to have become obsolete due to new technology. The production equipment would have a scrap value at the end of four years of $125,000 in future value terms.

Investment in working capital of $1.5 million will be required at the start of the first year of operation. Working capital inflation of 6% per year is expected and working capital will be recovered in full at the end of four years.

Hebac Co pays corporation tax of 20% per year, with the tax liability being settled in the year in which it arises. The company can claim tax-allowable depreciation on a 25% reducing balance basis on the initial investment cost, adjusted in the final year of operation for a balancing allowance or charge. Hebac Co currently has a nominal after-tax weighted average cost of capital (WACC) of 12% and a real after-tax WACC of 8.5%. The company uses its current WACC as the discount rate for all investment projects.

Required:

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

B. Discuss how the capital asset pricing model can assist Hebac Co in making a better investment decision with respect to its new product launch.

188. Pelta Co (Sep/Dec 17) ]

The directors of Pelta Co are considering a planned investment project costing $25m, payable at the start of the first year of operation. The following information relates to the investment project:

This information needs adjusting to take account of selling price inflation of 4% per year and variable cost inflation of 3% per year. The fixed costs, which are incremental and related to the investment project, are in nominal terms. The year 4 sales volume is expected to continue for the foreseeable future.

Pelta Co pays corporation tax of 30% one year in arrears. The company can claim tax-allowable depreciation on a 25% reducing balance basis.

The views of the directors of Pella Co are that all investment projects must be evaluated over four years of operations, with an assumed terminal value at the end of the fourth year of 5% of the initial investment cost. Both net present value and discounted payback must be used, with a maximum discounted payback period of two years. The real after-tax cost of capital of Pelta Co is 7% and its nominal after-tax cost of capital is 12%.

Required

(a) (i) Calculate the net present value of the planned investment project.

(ii) Calculate the discounted payback period of the planned investment project.

(b) Discuss the financial acceptability of the investment project.

C. Critically discuss the views of the directors on Pelta Co’s investment appraisal.

189. Melanie Co (Sept/Dec 18)

Melanie Co is considering the acquisition of a new machine with an operating life of three years. The new machine could be leased for three payments of $55,000, payable annually in advance.

Alternatively, the machine could be purchased for $160,000 using a bank loan at a cost of 8% per year. If the machine is purchased, Melanie Co will incur maintenance costs of $8,000 per year, payable at the end of each year of operation. The machine would have a residual value of $40,000 at the end of its three-year life.

Melanie Co’s production manager estimates that if maintenance routines were upgraded, the new machine could be operated for a period of four years with maintenance costs increasing to $12,000 per year, payable at the end of each year of operation. If operated for four years, the machine’s residual value would fall to $11,000. Taxation should be ignored.

Required

A. (i) Assuming that the new machine is operated for a three-year period, evaluate whether Melanie Co should use leasing or borrowing as a source of finance.

(ii) Using a discount rate of 10%, calculate the equivalent annual cost of purchasing and operating the machine for both three years and four years, and recommend which replacement interval should be adopted.

B. Critically discuss FOUR reasons why NPV is regarded as superior to IRR as an investment appraisal technique.

190. Hraxin Co (June 15 – Amended)

 Hraxin Co is appraising an investment project which has an expected life of four years and which will not be repeated. The initial investment, payable at the start of the first year of operation, is $5 million. Scrap value of $500,000 is expected to arise at the end of four years.

There is some uncertainty about what price can be charged for the units produced by the investment project, as this is expected to depend on the future state of the economy. The following forecast of selling prices and their probabilities has been prepared:

These selling prices are expected to be subject to annual inflation of 4% per year, regardless of which economic state prevails in the future.

Forecast sales and production volumes, and total nominal variable costs, have already been forecast, as follows:

Incremental overheads of $400,000 per year in current price terms will arise as a result of undertaking the investment project. A large proportion of these overheads relate to energy costs which are expected to increase sharply in the future because of energy supply shortages, so overhead inflation of 10% per year is expected.

The initial investment will attract tax-allowable depreciation on a straight-line basis over the four-year project life. The rate of corporation tax is 30% and tax liabilities are paid in the year in which they arise. Hraxin Co has traditionally used a nominal after-tax discount rate of 11% per year for investment appraisal.

Required:

A. Calculate the expected net present value of the investment project and comment on its financial acceptability.

B. Critically discuss if sensitivity analysis will assist Hraxin Co in assessing the risk of the investment project.