The following scenario relates to questions 35â€“39.**Â **

**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.

Year | 1 | 2 | 3 | 4 |

Net operating cash flow ($000) | 1,200 | 1,500 | 1,600 | 1,580 |

Scrap value ($000) | | | | 100 |

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.

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

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

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

39. Which of the following statements about Joy Co directorsâ€™ remuneration package is/are correct?

- Directorsâ€™ remuneration should be determined by senior executive directors.
- Introducing a share option scheme would help bring directorsâ€™ objectives in line with shareholdersâ€™ objectives.
- 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 40â€“44.

**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.

40. What is the discounted payback of the project?

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

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

44. 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 45â€“49.

**C****osta 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 Coâ€™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.

46. 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.

47. 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 Â Â Â Â Â Â Probability Â Â Â Â Â Â Strong $ Â Â Â Â Â Â Â Probability

Â Â Â Â Â Â Â Yes Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 0.4 Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Yes Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 0.3

Â Â Â Â Â Â Â Â No Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 0.6 Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â No Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 0.7

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

48. 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 true.

(1) It eliminates the effects of risk associated with various estimates.

(2) It requires probabilities of estimates subject to risk to be known.

49. Which of the following statements about Costa Coâ€™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 50â€“54.

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 1â€“1.9 million 2â€“2.9 million 3â€“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.

53. 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.

54. 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 Â Â Â 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 55-59.

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.

**Project ** | **Outlay in Year 0 $** | **PV $** | **NPV $** |

Amster | 100,000 | 111,400 | 11,400 |

Wind | 56,000 | 62,580 | 6,580 |

Ultra | 60,000 | 68,760 | 8,760 |

Tubor | 90,000 | 102,400 | 12,400 |

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

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

57. 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.

| 0 | 1 | 2 | 3 | 4 |

Maintenance costs | | (20,000) | (29,000) | (32,000) | (35,000) |

Investment and scrap | (250,000) | | | | 25,000 |

Net cash flow | (250,000) | (20,000) | (29,000) | (32,000) | (10,000) |

Discount at 12% | 1.000 | 0.893 | 0.797 | 0.712 | 0.636 |

Present values | (250,000) | Â (17,860) | Â (23,113) | (22,784) | (6,360) |

Tax and tax-allowable depreciation should be ignored.

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

58. 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.

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

Year Â Â Â Â Â Â Â Â Â Â Â Â Cash flow Â Â Â Â Â Â Â Probability $

Â 2 Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 19,000 Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 0.55

Â 2 Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 26,000 Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 0.45

Â 3Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 21,000 Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 0.3

Â 3 Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 25,000Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 0.25

Â 3 Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 31,000 Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 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 60-64.

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 projectsâ€™ cash flows is shown below.

Project | NPV $000 | Investment $000 |

A | 4,900 | 3,200 |

B | 7,400 | 9,300 |

C | 5,900 | 7,300 |

D | 7,500 | 5,200 |

E | 9,000 | 5,600 |

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.

60. 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

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

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

63. 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)?

64. 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 Â Â Â Â Â InvestÂ Â Â Â $4.00m

Time 1 Â Â Â Receive Â Â Â $8.80m

Time 2 Â Â Â Â Spend Â Â Â Â Â $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 65â€“69.

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.

| T1 | T2 | T3 | T4 |

Net cash flow $ | 122,000 | 143,000 | 187,000 | 78,000 |

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

66. 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.

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

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