Revision 2 Investment Appraisal

Topics List
1.

Investment Appraisal Methods

a. Payback period
Computation & comment
Advantages and disadvantages
Discounted payback period
b. Accounting rate of return (ARR)
Computation & comment

Advantages and disadvantages

c. Net present value (NPV)
Computation & comment

Exam Question
Reference

Jun 09
Jun 11

Q2b
Q1c

Pilot
Jun 09
Dec 12

Q4b
Q2b
Q1b

Jun 09
Dec 10

Q2b
Q1a,b

Dec 07
Jun 08
Jun 09
Dec 11
Pilot
Jun 10

Q2b
Q4b
Q2b
Q1b
Q4c
Q3c

Jun 09

Q2a

Pilot
Jun 08
Jun 09
Dec 10
Jun 11
Jun 12

Q4a
Q4a
Q2b
Q1a
Q1a
Q1a

Advantages and disadvantages

d. Internal rate of return (IRR)
Computation & comment

Advantages and disadvantages

2.

Stages in Capital Investment Projects

3.

Determination of relevant and non-relevant cash flows

4.

Allowing for Tax, Inflation and Working Capital

a. Inflation
Specific inflation and general inflation

22

Real and money interest rate Fishers equation

b. Taxation

c. Working capital

5.

Project Appraisal and Risk

a. Risk and uncertainty
b. Probability analysis

c. Sensitivity analysis

Dec 12
Jun 13
Dec 13
Jun 14
Pilot
Jun 10
Jun 13
Dec 13
Pilot
Dec 07
Jun 08
Dec 08
Jun 10
Dec 10
Jun 11
Dec 11
Jun 12
Dec 12
Jun 13
Dec 13
Jun 14
Jun 08
Dec 08
Jun 11
Dec 11
Jun 13
Dec 13

Q1a
Q1a
Q1a
Q1a
Q4a
Q3b
Q1b
Q1b
Q4a
Q2a
Q4a
Q3b
Q3b
Q1a
Q1a
Q1a
Q1a
Q1a
Q1a
Q1a,b
Q1a
Q4a
Q3b
Q1a
Q1a
Q1a
Q1a,b

Dec 07
Jun 11
Dec 07
Jun 11
Jun 12
Dec 07
Jun 11
Dec 11
Jun 12

Q2c
Q1c
Q2c
Q1c
Q1c
Q2c
Q1c
Q1c
Q1c

23

d. Simulation
e. Risk-adjusted discount rate
6.

Asset Investment Decisions

a. Lease or buy
Numerical analysis
Finance lease meaning
Operating lease meaning
Attractions of finance lease
Attractions of operating lease
b. Asset acquisition by NPV

c. Replacement cycles

d. Capital rationing
Hard (external) and soft (internal) capital rationing

Single period capital rationing

Multi-period capital rationing

Jun 10
Jun 11

Q3c(iii)
Q1c

Dec 09
Dec 13

Q1a,b
Q4a

Dec 13
Dec 13
Pilot
Dec 07
Jun 08
Dec 08
Dec 09
Jun 10
Jun 12

Q4b
Q4b
Q4a
Q2a
Q4a
Q3b
Q1b
Q3c
Q1b

Dec 11
Jun 14
Dec 09
Dec 11
Jun 14

Q1d
Q1c
Q1d
Q1d
Q1b

24

Chapter 4 Capital Budgeting and Basic Investment Appraisal Techniques

I.

Payback period and NPV

1.

Steeperton plc is committed to maximising the wealth of its shareholders.

Given this objective, which one of the following methods of investment appraisal is
most appropriate for the company to use?
A
B
C
D

2.

Net present value

Internal rate of return
Payback period
Accounting rate of return

Virunga Co uses the net present value (NPV) method, the internal rate of return (IRR)
method and discounted payback period (DPP) to appraise its new investment
opportunities. An investment opportunity was recently appraised using each of these
methods and was estimated to provide a positive NPV of $105 million, an IRR of 15%
and a DPP of three years. Following this appraisal, it was discovered that the cost of
capital of the company was lower than had been previously estimated.
What would be the effect (increase/decrease/no effect) on the figures provided by each
investment appraisal method of taking account of the lower cost of capital?

A
B
C
D
3.

NPV
Increase
Increase
Decrease
No effect

IRR
Increase
No effect
No effect
Decrease

DPP
Decrease
Decrease
Increase
No effect

Which ONE of the following methods of investment appraisal is consistent with the
objective of shareholder wealth maximisation?
A
B
C
D

Net present value

Internal rate of return
Accounting rate of return
Payback period

25

4.

A company is considering a project for investment which will cost $70,000 now and
another $10,000 in year five. The company has a cost of capital of 8%. The project has
the following discounted cash flows:
Year

Discounted cash flows

$
23,148
30,007
19,846
14,701

1
2
3
4

What is its discounted payback period in years and months (to the nearest month)?
A
B
C
D
5.

2 years, 10 months
3 years, 1 month
3 years, 3 months
3 years, 6 months

The payback period is the number of years that it takes a business to recover its original
investment from net returns, calculated
A
B
C
D

before both depreciation and taxation

before deprecation but after taxation
after deprecation but before taxation
after both depreciation and taxation

II.

Internal rate of return

6.

The net present value of a proposed project is $20,000 at a discount rate of 5% and
($28,000) at 10%.
What is the internal rate of return of the project, to the nearest one decimal place?
A
B
C
D

7.1%
7.5%
2.3%
8.6%

26

7.

The net present value of a proposed project is a positive $56,000 at a discount rate of
10% and a negative $28,000 at 20%.
What is the internal rate of return of the project, to the nearest whole percentage?
A 17%
B 13%
C 30%
D 8%

8.

Statement 1: Simple payback period takes into account the time value of money and
uses cash flows rather than profits.
Statement 2: Internal rate of return takes into account the time value of money and uses
cash flows rather than profits.
Which of the above statements is/are true?
A
B
C
D

9.

Statement 1 only
Statement 2 only
Both statement 1 and statement 2
Neither statement 1 nor statement 2

Sonoran Co recently evaluated an investment project that had an initial cash outlay
followed by positive annual net cash flows over its life. The company employed the
internal rate of return (IRR) and discounted payback period (DPP) methods for the
investment appraisal. Later, it was discovered that the cost of capital figure used was
incorrect and that the correct figure was higher.
What will be the effect on the IRR and DPP of correcting for this error?
Effect on
A
B
C
D

IRR
No change
Increase
Decrease
No change

DPP
No change
Increase
Decrease
Increase

27

10.

Maia plc is considering investing in two competing projects: Delta and Gamma. Delta
has a net present value (NPV) of $16,500 and an internal rate of return (IRR) of 17%.
Details of the estimated cash flows of Gamma are as follows:
$000
Cash flows
Year 0
Year 1
Year 2
Year 3

(200)
120
60
80

The business has a cost of capital of 10%.

Which one of the following combinations is correct concerning the NPV and IRR of the
two projects?

A
B
C
D
11.

Delta
Higher NPV
Higher NPV
Lower NPV
Lower NPV

Gamma
Higher IRR
Lower IRR
Higher IRR
Lower IRR

Calcite Ltd used the NPV and IRR methods of investment appraisal to evaluate a
project that has an initial cash outlay followed by annual net cash inflows over its life.
After the evaluation had been undertaken, it was discovered that the cost of capital had
been incorrectly calculated and that the correct cost of capital figure was in fact higher
than that used.
What will be the effect on the NPV and IRR figures of correcting for this error?
Effect on
A
B
C
D

NPV
Decrease
Decrease
Increase
Increase

IRR
Decrease
No change
Increase
No change

28

12.

A business evaluates an investment project that has an initial outlay followed by annual
net cash inflows of $10 million throughout its infinite life. The evaluation of the inflows
produced a present value of $50 million and a profitability (present value) index of 20.
What is the internal rate of return and initial outlay of this project?
What is the internal rate of return and initial outlay of this project?
IRR (%)
20
20
40
10

A
B
C
D
13.

Initial outlay ($m)

25
100
25
100

Romer plc used the IRR and discounted payback methods of investment appraisal to
evaluate an investment proposal that has an initial cash outlay followed by annual net
cash inflows over its life. Following this evaluation, it was found that the cost of capital
figure used was incorrect and that the correct figure was lower.
What will be the effect on the IRR and discounted payback period of correcting for this
error?

IRR figure
No change
Increase
Decrease
No change

A
B
C
D
14.

Effect on
Discounted payback period
No change
Increase
Decrease
Decrease

ABC Co wishes to undertake a project requiring an investment of $732,000 which will

generate equal annual inflows of $146,400 in perpetuity.
If the first inflow from the investment is a year after the initial investment, what is the
IRR of the project?
A
B
C
D

20%
25%
400%
500%
29

15.

Which of the following are advantages of the internal rate of return (IRR) approach to
investment appraisal?
1
2
3
4

Clear decision rule

Takes into account the time value of money
Assumes funds are re-invested at the IRR
Considers the whole project

A
B
C
D

1, 2 and 4 only
2, 3 and 4 only
2 and 4 only
1, 2 and 3 only

III. Accounting rate of return

16.

The following statements about the drawbacks of the accounting rate of return (ARR)
were made at a recent meeting:
1.
2.
3.

ARR is based on accounting profits and not cash flows, and can change because
profits are subject to different possible treatments.
ARR only considers cash flows within a given time period and ignores cash flows
after that time period.
With the ARR method $1 receivable today is worth the same as a $1 in five years.
Therefore it ignores the time value of money.

Which combination of the above statements is true?

A
B
C
D

1, 2 and 3
1 and 2 only
1 and 3 only
2 and 3 only

30

17.

A company purchases a non-current asset with a useful economic life of ten years for
$1.25 million. It is expected to generate cash flows over the ten year period of $250,000
per annum before depreciation. The company charges depreciation over the life of the
asset on a straight-line basis. At the end of the period it will be sold for $250,000.
What is the accounting rate of return for the investment (based on average profits and
average investment)?
A
B
C
D

18.

20%
15%
33%
25%

Consider the following statements concerning investment appraisal methods.

1.
2.
3.
4.

The accounting rate of return method ignores the time value of money.
The internal rate of return method ignores the relative size of investments when
ranking investment proposals.
The net present value method ignores the required returns from investors when
ranking investment proposals.
The payback method ignores non-operating cash flows relating to an investment
proposal when calculating the payback period.

Which two of the above statements are correct?

A
B
C
D

1 and 2
1 and 3
2 and 4
3 and 4

31

IV. Relevant cash flows

19.

An accountant is paid $30,000 per annum and spends two weeks one month working on
appraising project Alpha.
Why should the accountant NOT charge half his salary to the project?
A
B
C
D

20.

Because his salary is sunk

Because his salary is not incremental
Because his salary is not a cash flow
Because his salary is an opportunity cost

Elara plc is considering an investment in a new process. The new process will require
an increase in stocks of $30,000 during the first year. There will also be an increase in
debtors outstanding of $40,000 and an increase of creditors outstanding of $35,000
during the first year. The new process will use machinery that was purchased
immediately before the first year of operations at a cost of $300,000. The machinery is
depreciated using the straight-line method and has an estimated life of five years and no
residual value. During the first year, the net operating profit before depreciation from
the new process is expected to be $180,000. The business uses the net present value
method when evaluating investment proposals.
When undertaking the net present value calculations, what would be the estimated net
cash flow during the first year of the project? (Ignore taxation)
A
B
C
D

$85,000
$215,000
$145,000
$155,000

32

21.

Merton plc is currently considering a new investment project and uses the NPV method
for appraisal purposes.
Which one of the following items relating to the project should be included in the NPV
appraisal?
A
B
C
D

22.

The payment of $30,000 for a market research report, which was commissioned
last month and will be paid for next month.
The apportionment of fixed costs of $10,000 per year over the life of the project to
represent a fair share of the total fixed costs of the factory.
An offer of $100,000 to acquire raw materials that were due to be sold but which
will be used in the project if it goes ahead.
A depreciation charge of $10,000 per year over the life of the project for
machinery that will be used in the project.

LW Co has a half empty factory on which it pays $5,000 pa. If it takes on a new project,
it will have to move to a new bigger factory costing $17,000 pa and it could rent the old
factory out for $3,000 pa until the end of the current lease.
What is the rental cost to be included in the project appraisal?
A
B
C
D

$14,000
$17,000
$9,000
$19,000

33

Chapter 5 DCF with Inflation and Taxation

I.

Inflation

1.

When appraising investment projects using discounted cash flow methods, two
approaches to dealing with inflation could be used. These are:
1.
2.

to exclude inflation from the estimated future cash flows and to apply a discount
rate based on the money cost of capital.
to include inflation in the estimated future cash flows and to apply a discount
based on the real cost of capital.

Which ONE of the following combinations (true/false) concerning the above statements
is correct?

A
B
C
D
2.

Statement 1
True
True
False
False

Statement 2
True
False
True
False

To deal with the effect of inflation when appraising investment projects, two possible
approaches can be used. These are:
1.
2.

To exclude inflation from the estimated future cash flows and to apply a discount
rate expressed in real terms.
To adjust the estimated future cash flows by the relevant rates of inflation and to
adjust the discount rate to reflect current market rates.

Which one of the following combinations is correct?

A
B
C
D

Statement 1
True
True
False
False

Statement 2
True
False
True
False

34

3.

The one year rate of inflation is expected to be 30%. The one year money rate of
interest is 63%.
The one year real rate of interest is:
A
B
C
D

4.

330%
320%
930%
949%.

Dunlin plc is examining an investment opportunity that will lead to savings in staff
costs. The company uses the net present value method of investment appraisal based on
cash flows expressed in real terms. Staff costs are expected to rise at a rate of 5% each
year, whereas the general rate of inflation is expected to rise at a rate of 3% each year.
The company has a required rate of return of 10%, assuming no inflation.
What is the appropriate discount rate to use when evaluating the investment
opportunity?
A
B
C
D

5.

10%
13%
133%
155%.

Consider the following statements.

When using the net present value method of investment appraisal, the required rate of
return from investors is used as the appropriate discount factor. This rate of return
should be:
(1)
(2)

calculated on an after-tax basis

expressed in real terms if the cash flows are expressed in terms of the actual
number of dollars to be received.

Which one of the following combinations (true/false) concerning the above statements
is correct?

35

Statement 1
True
True
False
False

A
B
C
D
6.

Statement 2
True
False
True
False

A project consists of a series of cash outflows in the first few years followed by a series
of positive cash inflows. The total cash inflows exceed the total cash outflows. The
project was originally evaluated assuming a zero rate of inflation.
If the project were re-evaluated on the assumption that the cash flows were subject to a
positive rate of inflation, what would be the effect on the payback period and the
internal rate of return?
Payback
Increase
Decrease
Decrease
Increase

A
B
C
D
7.

IRR
Increase
Decrease
Increase
Decrease

Spotty Ltd plans to purchase a machine costing $18,000 to save labour costs. Labour
savings would be $10,000 in the first year and labour rates in the second year will
increase by 10%. The estimated average annual rate of inflation is 9% and the
companys real cost of capital is estimated at 11%. The machine has a two year life with
an estimated actual salvage value of $5,000 receivable at the end of year 2. All cash
flows occur at the year end.
What is the NPV (to the nearest $10) of the proposed investment?
A
B
C
D

$50
$270
$370
$1,430

36

8.

A project has an initial outflow at year 0 when an asset is bought, then a series of
revenue inflows at the end of each year, and then finally sales proceeds from the sale of
the asset. Its NPV is $12,000 when general inflation is zero % per year.
If general inflation were to be rise to 7% per year, and all revenue inflows were subject
to this rate of inflation but the initial expenditure and resale value of the asset were not
subject to inflation, what would happen to the NPV?
A
B
C
D

The NPV would remain the same

The NPV would rise
The NPV would fall
The NPV could rise or fall

II.

Taxation

9.

A company has 31 December as its accounting year end. On 1 January 2014 a new
machine costing $2,000,000 is purchased. The company expects to sell the machine on
31 December 2015 for $350,000.
The rate of corporation tax for the company is 30%. Tax-allowable depreciation is
obtained at 25% on the reducing balance basis, and a balancing allowance is available
on disposal of the asset. The company makes sufficient profits to obtain relief for
capital allowances as soon as they arise.
If the companys cost of capital is 15% per annum, what is the present value of the taxallowable depreciation at 1 January 2014 (to the nearest thousand dollars)?
A
B
C
D

$391,000
$248,000
$263,000
$719,000

37

10.

Jones Ltd plans to spend $90,000 on an item of capital equipment on 1 January 2012.
The expenditure is eligible for 25% tax-allowable depreciation, and Jones pays
corporation tax at 30%. Tax is paid at the end of the accounting period concerned. The
equipment will produce savings of $30,000 per annum for its expected useful life
deemed to be receivable every 31 December. The equipment will be sold for $25,000 on
31 December 2015. Jones has a 31 December year end and has a 10% post-tax cost of
capital.
What is the present value at 1 January 2012 of the tax savings that result from the
capital allowances?
A
B
C
D

11.

$13,170
$15,826
$16,018
$19,827

A company receives a perpetuity of $20,000 per annum in arrears, and pays 30%
corporation tax 12 months after the end of the year to which the cash flows relate.
At a cost of capital of 10%, what is the after tax present value?
A
B
C
D

$140,000
$145,460
$144,000
$127,274

III. Incorporating working capital

12.

A project has the following projected cash inflows.

Year 1 100,000
Year 2 125,000
Year 3 105,000
Working capital is required to be in place at the start of each year equal to 10% of the
cash inflow for that year. The cost of capital is 10%.
What is the present value of the working capital?
38

A
B
C
D
13.

$ Nil
$(30,036)
$(2,735)
$33,000

AW Co needs to have $100,000 working capital in place immediately for the start of a 2
year project. The amount will stay constant in real terms. Inflation is running at 10% per
annum, and AW Cos money cost of capital is 12%.
What is the present value of the cash flows relating to working capital?
A
B
C
D

$(21,260)
$(20,300)
$(108,730)
$(4,090)

Question 1 NPV, IRR and ARR with inflation

PV Co is evaluating an investment proposal to manufacture Product W33, which has
performed well in test marketing trials conducted recently by the companys research and
development division. The following information relating to this investment proposal has
now been prepared:
Initial investment
Selling price (current price terms)
Expected selling price inflation
Variable operating costs (current price terms)
Fixed operating costs (current price terms)
Expected operating cost inflation

$2 million
$20 per unit
3% per year
$8 per unit
$170,000 per year
4%

The research and development division has prepared the following demand forecast as a
result of its test marketing trials. The forecast reflects expected technological change and its
effect on the anticipated life-cycle of Product W33.
Year
Demand (units)

1
60,000

2
70,000

3
120,000

4
45,000

39

It is expected that all units of Product W33 produced will be sold, in line with the
companys policy of keeping no inventory of finished goods. No terminal value or
machinery scrap value is expected at the end of four years, when production of Product
W33 is planned to end. For investment appraisal purposes, PV Co uses a nominal (money)
discount rate of 10% per year and a target return on capital employed of 30% per year.
Ignore taxation.
Required:
(a)

(b)

Calculate the following values for the investment proposal:

(i) net present value;
(5 marks)
(ii) internal rate of return, and;
(3 marks)
(iii) return on capital employed (accounting rate of return) based on average
investment.
(3 marks)
Discuss briefly your findings in each section of (a) above and advise whether the
investment proposal is financially acceptable.
(4 marks)
(15 marks)
(ACCA F9 Financial Management Pilot Paper 2014 Q4)

Question 2 NPV, IRR, replacement cycles and project adjusted discount rate
The following draft appraisal of a proposed investment project has been prepared for the
finance director of OKM Co by a trainee accountant. The project is consistent with the
current business operations of OKM Co.
Year
1
2
3
4
5
Sales (units/yr)
250,000
400,000
500,000
250,000
$000
$000
$000
$000
$000
Contribution
1,330
2,128
2,660
1,330
Fixed costs
(530)
(562)
(596)
(631)
Depreciation
(438)
(438)
(437)
(437)
Interest payments
(200)
(200)
(200)
(200)
Taxable profit
Taxation

162

Profit after tax

Scrap value
After-tax cash flows
Discount at 10%
Present values

928
(49)

1,427
(278)

62
(428)

162

879

1,149

(366)
250

(19)

162
0.909

879
0.826

1,149
0.751

(116)
0.683

(19)
0.621

147

726

863

(79)

(12)

(19)

40

Net present value = 1,645,000 2,000,000 = ($355,000) so reject the project.

The following information was included with the draft investment appraisal:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

The initial investment is $2 million

Selling price: $12/unit (current price terms), selling price inflation is 5% per year
Variable cost: $7/unit (current price terms), variable cost inflation is 4% per year
Fixed overhead costs: $500,000/year (current price terms), fixed cost inflation is 6%
per year
$200,000/year of the fixed costs are development costs that have already been incurred
and are being recovered by an annual charge to the project
Investment financing is by a $2 million loan at a fixed interest rate of 10% per year
OKM Co can claim 25% reducing balance capital allowances on this investment and
pays taxation one year in arrears at a rate of 30% per year
The scrap value of machinery at the end of the four-year project is $250,000
The real weighted average cost of capital of OKM Co is 7% per year
The general rate of inflation is expected to be 4.7% per year

Required:
(a)
(b)
(c)

Identify and comment on any errors in the investment appraisal prepared by the trainee
accountant.
(5 marks)
Prepare a revised calculation of the net present value of the proposed investment
project and comment on the projects acceptability.
(12 marks)
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)
(25 marks)
(ACCA F9 Financial Management June 2010 Q3)

Question 3 NPV with inflation, working capital changes and discussion with risk
incorporation
BRT Co has developed a new confectionery line that can be sold for $500 per box and that is

41

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 in the evaluation. The variable and fixed costs (both in
current price terms) will depend on sales volume, as follows.
Sales volume (boxes)
Variable costs ($ per box)
Total fixed costs ($)

less than 1 million

1 1.9 million

2 2.9 million

3 3.9 million

2.8

3.00

3.00

3.05

1 million

1.8 million

2.8 million

3.8 million

0.7 million

1.6 million

2.1 million

3.0 million

Forecast sales volumes are as follows.

Year
Demand (boxes)

The production equipment for the new confectionery line would cost $2 million and an
additional initial investment of $750,000 would be needed for working capital. Capital
allowances (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.
The average general level of inflation is expected to be 3% per year and selling price, variable
costs, fixed costs and working capital would all experience inflation of this level. BRT Co
uses a nominal after-tax cost of capital of 12% to appraise new investment projects.
Required:
(a)

(b)

(c)

Assuming that production only lasts for four years, calculate the net present value of
investing in the new product using a nominal terms approach and advise on its financial
acceptability (work to the nearest $1,000).
(13 marks)
Comment briefly on the proposal to use a four-year time horizon, and calculate and
discuss a value that could be placed on after-tax cash flows arising after the fourth year
of operation, using a perpetuity approach. Assume, for this part of the question only,
that before-tax cash flows and profit tax are constant from year five onwards, and that
capital allowances and working capital can be ignored.
(5 marks)
Discuss THREE ways of incorporating risk into the investment appraisal process.
(7 marks)

42

(25 marks)
(ACCA F9 Financial Management June 2011 Q1)

Question 4 NPV with nominal and real approach, working capital changes
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. Capital allowances 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:

Selling price
Variable cost
Incremental fixed costs

$650 per unit

$250 per unit
$250,000 per year

Forecast inflation
4.0% per year
5.5% 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 47% 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)

(b)
(c)

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.
(14 marks)
Discuss the difference between a nominal (money terms) approach and a real terms
approach to calculating net present value.
(5 marks)
Identify TWO financial objectives of a listed company such as HDW Co and discuss
how each of these financial objectives is supported by the planned investment in new

43

machinery.

(6 marks)
(25 marks)
(ACCA F9 Financial Management June 2013 Q1)

44

Chapter 6 Project Appraisal and Risk

I.

Sensitivity analysis

1.

The following financial information relates to an investment project:

Present value of sales revenue

Present value of variable costs

$000
50,025
25,475

Present value of contribution

Present value of fixed costs

24,550
18,250

Present value of operating income

Initial investment

6,300
5,000

Net present value

1,300

What is the sensitivity of the net present value of the investment project to a
change in sales volume?
A
B
C
D

71%
26%
51%
53%
(ACCA F9 Financial Management Pilot Paper 2014)

2.

Arnold is contemplating purchasing for $280,000 a machine which he will use to

produce 50,000 units of a product per annum for five years. These products will be sold
for $10 each and unit variable costs are expected to be $6. Incremental fixed costs will
be $70,000 per annum for production costs and $25,000 per annum for selling and
administration costs. Arnold has a required return of 10% per annum.
By how many units must the estimate of production and sales volume fall for the project
to be regarded as not worthwhile?
A
B
C
D

2,875
7,785
8,115
12,315

45

3.

A project has the following cash flows.

T0
T1-4

Outflow $110,000
Inflow $40,000

At the companys cost of capital of 10% the NPV of the project is $16,800.
Applying sensitivity analysis to the cost of capital, what percentage change in the cost
of capital would cause the project NPV to fall to zero.?
A
B
C
D

70%
17%
5%
41%

II.

Expected value

4.

A risk averse investor is considering four mutually exclusive investments, which have
the following characteristics:
Project

Expected return

Alpha
Beta
Gamma
Delta

15%
14%
25%
12%

Standard deviation of
expected returns
5%
8%
10%
5%

Which two of the above investments will the investor immediately REJECT?
A
B
C
D

Alpha and Beta

Alpha and Gamma
Gamma and Delta
Beta and Delta

46

5.

When using the expected value criterion, it is assumed that the individual wants to
A
B
C
D

6.

The lower risk of a project can be recognized by increasing

A
B
C
D

7.

8.

Minimise risk for a given level of return

Maximise return for a given level of risk
Minimise risk irrespective of the level of return
Maximise return irrespective of the level of risk

The cost of the initial investment of the project

The estimates of future cash inflows from the project
The internal rate of return of the project
The required rate of return of the project

Which of the following are true in respect of using expected values in net present value
calculations?
1
2
3
4

Appropriate for one-off events

Hides risk
Probably wont actually occur
Eliminates uncertainty

A
B
C
D

1, 2 and 3 only
3 and 4 only
2 and 3 only
1, 2 and 4

Sales volumes are expected to be either 20,000 units with 60% probability or they are
expected to be 25,000 units. Price will either be $10 (0.3 probability) or else $15.
Margins are expected to be 30% or 40% of sales with an even chance of each.
What is the expected total cost?
A
B
C
D

$103,950
$193,050
$297,000
$105,000

47

III. Simulation
9.

When considering investment appraisal under uncertainty, a simulation exercise

A
B
C
D

10.

Considers the effect of changing one variable at a time

Considers the impact of many variables changing at the same time
Points directly to the correct investment decision
Assesses the likelihood of a variable changing

What is the main advantage of using simulations to assist in investment appraisal?

A
B
C
D

A clear decision rule

More than one variable can change at a time
Statistically more accurate than other methods
Being diagrammatic it is easier to understand

Question 5 Risk, uncertainty, payback, sensitivity analysis and ENPV

Umunat plc is considering investing $50,000 in a new machine with an expected life of five
years. The machine will have no scrap value at the end of five years. It is expected that
20,000 units will be sold each year at a selling price of $300 per unit. Variable production
costs are expected to be $165 per unit, while incremental fixed costs, mainly the wages of a
maintenance engineer, are expected to be $10,000 per year. Umunat plc uses a discount rate
of 12% for investment appraisal purposes and expects investment projects to recover their
initial investment within two years.
Required:
(a)
(b)
(c)

Explain why risk and uncertainty should be considered in the investment appraisal
process.
(5 marks)
Calculate and comment on the payback period of the project.
(4 marks)
Evaluate the sensitivity of the projects net present value to a change in the following
project variables:
(i) sales volume;
(ii) sales price;
(iii) variable cost;
and discuss the use of sensitivity analysis as a way of evaluating project risk.
(10 marks)

48

(d)

Upon further investigation it is found that there is a significant chance that the
expected sales volume of 20,000 units per year will not be achieved. The sales
manager of Umunat plc suggests that sales volumes could depend on expected
economic states that could be assigned the following probabilities:
Economic state
Probability
Annual sales volume (units)

Poor
0.3
17,500

Normal
0.6
20,000

Good
0.1
22,500

Calculate and comment on the expected net present value of the project.

(6 marks)
(25 marks)
(ACCA 2.4 Financial Management and Control December 2004 Q5)

Question 6 ENPV
Carcross Co engages in off-shore drilling operations for oil deposits. The company has
recently spent $5 million in surveying a region in the Gulf of Mexico and has found the
existence of significant oil deposits there. The sea bed in the region, however, has a rock
formation that may make access to the oil deposits difficult. The total oil deposits in the
region have been estimated at 30 million barrels but the amount extracted will vary
according to the conditions faced when drilling operations commence. The companys
senior geologist believes that three possible outcomes are likely from drilling operations and
has made the following estimates concerning the percentage of total oil deposits that will be
extracted under each outcome:
Outcome
1
2
3

Percentage of total oil

deposits extracted
100%
40%
25%

Probability
0.1
0.5
0.4

If the company decides to go ahead with the drilling operation, an immediate payment of
$40 million for drilling rights, along with annual payments of $5 for each barrel of oil
extracted must be made to the Mexican government. Equipment costing $125 million must
be acquired immediately but drilling will not commence until the second year of the fouryear licence period. It is expected that, whichever of the above outcomes arise, the oil will
be extracted evenly over the drilling period. Annual operating costs (excluding any

49

payments to the Mexican government) will be $120 million in the first year and $160
million for each of the remaining three years of the licence. At the end of the licence period,
the equipment will be sold at a price that is equal to its original cost less $8 for each barrel
of oil that has been extracted.
Oil prices over the period of the drilling licence are estimated to be as follows:
Year
1
2
3
4

Price per barrel

$70
$85
$75
$100

The company has a cost of capital of 14%.

Workings should be in $millions and to one decimal place.
Required:
(a)
(b)
(c)
(d)

Calculate the expected net present value (ENPV) of the investment proposal.
(10 marks)
Calculate the net present value of the worst possible outcome.
(5 marks)
Comment on the results of your calculations in (a) and (b) above.
(2 marks)
Discuss the weaknesses of the ENPV approach for decision-making purposes.
(3 marks)
(20 marks)

50

Chapter 7 Asset Investment Decisions and Capital Rationing

I.

Lease or Buy

1.

Consider the following two statements concerning finance leasing.

1.
2.

The lessor is responsible for the maintenance and servicing of the asset
The period of the lease will cover all, or substantially all, of the useful economic
life of the leased asset.

Which one of the following combinations (true/false) concerning the above statements
is correct?

A
B
C
D
2.

3.

Statement 1
True
True
False
False

Statement 2
True
False
True
False

Which of the following relate to finance leases as opposed to operating leases?

1
2
3

Maintained and insured by the lessor

Asset appears on statement of financial position of lessee
Equipment leased for a shorter period than its expected useful life

A
B
C
D

2 only
1 and 2 only
2 and 3 only
1 and 3 only

AB Co is considering either leasing an asset or borrowing to buy it, and is attempting to

analyse the options by calculating the net present value of each. When comparing the
two, AB Co is uncertain whether they should include interest payments in their option
to borrow and buy as it is a future, incremental cash flow associated with that option.
They are also uncertain which discount rate to use in the net present value calculation
for the lease option.
How should AB Co treat the interest payments and what discount rate should they use?
51

A
B
C
D

Include interest?
Yes
Yes
No
No

Discount rate
After tax cost of the loan if they borrow and buy
AB Cos WACC
After tax cost of the loan if they borrow and buy
AB Cos WACC

Question 7 Purchase or Lease the New Machine

AGD Co is a profitable company which is considering the purchase of a machine costing
320,000. If purchased, AGD Co would incur annual maintenance costs of 25,000. The
machine would be used for three years and at the end of this period would be sold for
50,000. Alternatively, the machine could be obtained under an operating lease for an annual
lease rental of 120,000 per year, payable in advance.
AGD Co can claim capital allowances on a 25% reducing balance basis. The company pays
tax on profits at an annual rate of 30% and all tax liabilities are paid one year in arrears.
AGD Co has an accounting year that ends on 31 December. If the machine is purchased,
payment will be made in January of the first year of operation. If leased, annual lease rentals
will be paid in January of each year of operation.
Required:
(a)
(b)

Using an after-tax borrowing rate of 7%, evaluate whether AGD Co should purchase or
lease the new machine.
(12 marks)
Explain and discuss the key differences between an operating lease and a finance lease.
(8 marks)
(Amended ACCA Paper 2.4 Financial Management and Control December 2005 Q4)

52

Question 8 Purchase or Lease the New Machine

Spot Co is considering how to finance the acquisition of a machine costing $750,000 with
an operating life of five years. There are two financing options.
Option 1
The machine could be leased for an annual lease payment of $155,000 per year, payable at
the start of each year.
Option 2
The machine could be bought for $750,000 using a bank loan charging interest at an annual
rate of 7% per year. At the end of five years, the machine would have a scrap value of 10%
of the purchase price. If the machine is bought, maintenance costs of $20,000 per year
would be incurred.
Taxation must be ignored.
Required:
(a)
(b)

Evaluate whether Spot Co should use leasing or borrowing as a source of finance,

explaining the evaluation method which you use.
(10 marks)
Discuss the attractions of leasing as a source of both short-term and long-term finance.
(5 marks)
(Adapted ACCA F9 Financial Management December 2013 Q4(a)& (b)

53

II.

Asset Replacement Decision

4.

A company buys a machine for $10,000 and sells it for $2,000 at year 3. Running costs
of the machine are: year 1 = $3,000; year 2 = $5,000; year 3 = $7,000.
If a series of machines are brought, run and sold on an infinite cycle of replacements,
what is the equivalent annual cost of the machine if the discount rate is 10%?
A
B
C
D

5.

$22,114
$8,288
$246
$7,371

PD Co is deciding whether to replace its delivery vans every year or every other year.
The initial cost of a van is $20,000. Maintenance costs would be nil in the first year, and
$5,000 at the end of the second year. Second-hand value would fall from $10,000 to
$8,000 if it held on to the van for two years instead of just one. PD Cos cost of capital
is 10%.
How often should PD Co replace their vans, and what is the annual equivalent cost
(EAC) of that option?

A
B
C
D
6.

Replace every
1
1
2
2

EAC ($)
10,910
12,002
10,093
8,761

A professional kitchen is attempting to choose between gas and electricity for its main
heat source. Once a choice is made, the kitchen intends to keep to that source
indefinitely. Each gas oven has a net present value (NPV) of $50,000 over its useful life
of 5 years. Each electric oven has an NPV of $68,000 over its useful life of 7 years. The
cost of capital is 8%.
Which should the kitchen choose and why?
A
B

Gas because its average NPV per year is higher than electric
Electric because its NPV is higher than gas
54

C
D

Electric because its equivalent annual benefit is higher

Electric because it lasts longer than gas

Question 9 Purchase of New Machine and IRR

Duo Co needs to increase production capacity to meet increasing demand for an existing
product, Quago, which is used in food processing. A new machine, with a useful life of
four years and a maximum output of 600,000 kg of Quago per year, could be bought for
$800,000, payable immediately. The scrap value of the machine after four years would be
$30,000. Forecast demand and production of Quago over the next four years is as follows:
Year
Demand (units)

1
1.4 million

2
1.5 million

3
1.6 million

4
1.7 million

Existing production capacity for Quago is limited to one million kilograms per year and the
new machine would only be used for demand additional to this.
The current selling price of Quago is $8.00 per kilogram and the variable cost of materials
is $5.00 per kilogram. Other variable costs of production are $1.90 per kilogram. Fixed
costs of production associated with the new machine would be $240,000 in the first year of
production, increasing by $20,000 per year in each subsequent year of operation.
Duo Co pays tax one year in arrears at an annual rate of 30% and can claim capital
allowances (tax-allowable depreciation) on a 25% reducing balance basis. A balancing
allowance is claimed in the final year of operation.
Duo Co uses its after-tax weighted average cost of capital when appraising investment
projects. It has a cost of equity of 11% and a before-tax cost of debt of 86%. The long-term
finance of the company, on a market-value basis, consists of 80% equity and 20% debt.
Required:
(a)
(b)

(c)

Calculate the net present value of buying the new machine and advise on the
acceptability of the proposed purchase (work to the nearest $1,000).
(13 marks)
Calculate the internal rate of return of buying the new machine and advise on the
acceptability of the proposed purchase (work to the nearest $1,000).
(4 marks)
Explain the difference between risk and uncertainty in the context of investment

55

appraisal, and describe how sensitivity analysis and probability analysis can be used to
incorporate risk into the investment appraisal process.
(8 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2007 Q2)
Question 10 NPV, Equivalent Annual Cost, Sensitivity and Profitability Analysis
Ridag Co is evaluating two investment projects, as follows.
Project 1
This is an investment in new machinery to produce a recently-developed product. The cost
of the machinery, which is payable immediately, is $15 million, and the scrap value of the
machinery at the end of four years is expected to be $100,000. Capital allowances (taxallowable depreciation) can be claimed on this investment on a 25% reducing balance basis.
Information on future returns from the investment has been forecast to be as follows:
Year
Sales volume (units/year)
Selling price ($/unit)
Variable cost ($/unit)
Fixed costs ($/year)

1
50,000
25.00
10.00
105,000

2
95,000
24.00
11.00
115,000

3
140,000
23.00
12.00
125,000

4
75,000
23.00
12.50
125,000

This information must be adjusted to allow for selling price inflation of 4% per year and
variable cost inflation of 25% per year. Fixed costs, which are wholly attributable to the
project, have already been adjusted for inflation. Ridag Co pays profit tax of 30% per year
one year in arrears.
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 $50,000 after
three years. Annual maintenance costs of the two machines are as follows:
Year
Machine 1 ($/year)
Machine 2 ($/year)

1
25,000
15,000

2
29,000
20,000

3
32,000
25,000

4
35,000

Where relevant, all information relating to Project 2 has already been adjusted to include

56

expected future inflation. Taxation and capital allowances 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)
(b)
(c)

Calculate the net present value of Project 1 and comment on whether this project is
financially acceptable to Ridag Co.
(12 marks)
Calculate the equivalent annual costs of Machine 1 and Machine 2, and discuss which
machine should be purchased.
(6 marks)
Critically discuss the use of sensitivity analysis and probability analysis as ways of
including risk in the investment appraisal process, referring in your answer to the
relative effectiveness of each method.
(7 marks)
(25 marks)
(ACCA F9 Financial Management June 2012 Q1)

III. Capital Rationing

7.

The profitability index may be used in investment decisions where capital rationing
exists. In this context, when selecting investments for an optimal portfolio, the use of
the profitability index is appropriate only where:
1.
2.

projects are divisible.

capital rationing occurs within a single investment period.

Which one of the following combinations (true/false) relating to the above statements is
correct?

A
B
C
D

Statement 1
True
True
False
False

Statement 2
True
False
True
False

57

8.

Glarus Co is considering four separate investment opportunities but only has limited
funds to invest during the current year. This means that the company will not be able to
invest fully in all four opportunities. Each investment opportunity is divisible (i.e. it is
possible to undertake part of an investment and to receive a pro rata return). Details of
each investment opportunity are as follows:
Investment opportunity

Initial outlay
$m
186
65
100
50

Kurai
Barisan
Carnic
Flinders

PV of net cash inflows

$m
211
84
120
71

How should the investment opportunities be ranked if Glarus Co wishes to maximise

the wealth of its shareholders?

1
Flinders
Kurai
Flinders
Kurai
st

A
B
C
D
9.

Project ranking
2
3rd
Barisan
Carnic
Carnic
Barisan
Carnic
Barisan
Flinders
Carnic
nd

4th
Kurai
Flinders
Kurai
Barisan

Thera Co is considering an investment in one of two mutually-exclusive projects. The

company is committed to maximising the wealth of its shareholders. Details of each
project, which have the same level of risk, are as follows:

Project Alpha
Project Beta

Discounted
payback
3 years
4 years

Profitability
index
1.5
1.6

Internal rate
of return
18%
19%

Net present
value
$80,000
$75,000

Which project should be selected and for what reason?

A
B
C
D

Project Alpha because it has the shorter discounted payback period

Project Alpha because it has the higher net present value
Project Beta because it has the higher profitability index
Project Beta because it has the higher internal rate of return
58

10.

Where there is capital rationing, the profitability index (PI) may be used to rank
investment projects with a positive net present value. It has been claimed that using the
PI is appropriate only when:
1.
2.

Capital rationing is for a single period.

The investment projects are indivisible.

Which ONE of the following combinations (true/false) concerning the above statements
is correct?

A
B
C
D
11.

Statement 1
True
True
False
False

Statement 2
True
False
True
False

A company has $500,000 available for investment and is considering the following four
divisible, but not repeatable, projects to invest in:

Project One
Project Two
Project Three
Project Four

Initial outlay
$300,000
$100,000
$200,000
$150,000

Net present value

$60,000
$40,000
$50,000
$45,000

Profitability index
1.20
1.40
1.25
1.30

What is the maximum net present value the company can generate from its investment?
A
B
C
D

$195,000
$145,000
$135,000
$110,000

59

12.

Fulmar plc is currently considering three investment opportunities. Details of each

opportunity are given below:
Investment opportunity
Alpha
Beta
Gamma
$m
$m
$m
80
140
90

Initial outlay
Future net inflows
Year 1
Year 2

190
10

180
120

10
220

The company has a capital budget that is restricted in the year of the investment and it
will not be possible to undertake all three projects in full. The investment opportunities
are independent of one another and each project is divisible (that is, it is possible to
undertake part of an investment and to receive a pro rata return). The cost of capital of
the company is 12 per cent and the company uses the net present value method of
investment appraisal.
Which of the following is the correct ranking of the three investment opportunities?

A
B
C
D
13.

1
Alpha
Beta
Beta
Gamma

Ranking
2
Gamma
Gamma
Alpha
Alpha

3
Beta
Alpha
Gamma
Beta

Purus plc is considering four possible investment projects for the current year but has
only a limited amount to invest. As a result it will not be able to undertake in full all of
the projects available. All of the projects are divisible (i.e. it is possible to undertake
part of a project and to receive a pro rata return). Details of each project are as follows:
Project
Japura
Branco
Tapajos
Napo

Investment outlay
$m
40
45
60
70

Present value of net cash inflows

$m
48
64
66
92
60

In what order should they be ranked if the business wishes to maximise the wealth of its
shareholders?

A
B
C
D
14.

4
Napo
Napo
Tapajos
Japura

Keble plc is considering an investment project that has an initial outlay followed by
constant annual net cash inflows throughout its infinite life. The present value of the
project is $40 million and the internal rate of return on the project is 20%. The project
has a profitability (present value) index of 40.
What are the annual net cash inflows and initial outlay of this project?

A
B
C
D
15.

1
Japura
Tapajos
Branco
Napo

Project ranking
2
3
Branco
Tapajos
Branco
Japura
Napo
Japura
Tapajos
Branco

Annual net cash inflows

($m)
1.6
2.0
50.0
32.0

Initial outlay
($m)
8.0
10.0
10.0
160.0

The directors of Hybris plc are considering the following investment projects:

Project Leo
Project Taurus
Project Pisces

Initial outlay
$000
450
285
240

Total present value

$000
560
370
330

The directors have a limited capital expenditure budget and cannot invest in all
profitable projects. All projects are divisible.
Assuming that the company wishes to maximise the wealth of its shareholders, what
should be the order of priority for the three projects?

61

A
B
C
D
16.

Leo
1
1
3
2

Order of priority
Taurus
3
2
2
3

Pisces
2
3
1
1

Which of the following are potentially practical ways of attempting to deal with a
capital constraint?
1
2
3

Lease
Joint venture
Delay one or more of the projects

A
B
C
D

1 and 3 only
2 and 3 only
1 and 2 only
1, 2 and 3

Question 11 Capital rationing and relevant cash flows

Basril plc is reviewing investment proposals that have been submitted by divisional
managers. The investment funds of the company are limited to $800,000 in the current year.
Details of three possible investments, none of which can be delayed, are given below.
Project 1
An investment of $300,000 in work station assessments. Each assessment would be on an
individual employee basis and would lead to savings in labour costs from increased
efficiency and from reduced absenteeism due to work-related illness. Savings in labour costs
from these assessments in money terms are expected to be as follows:
Year
Cash flows ($000)

1
85

2
90

3
95

4
100

5
95

Project 2
An investment of $450,000 in individual workstations for staff that is expected to reduce
administration costs by $140,800 per annum in money terms for the next five years.

62

Project 3
An investment of $400,000 in new ticket machines. Net cash savings of $120,000 per
annum are expected in current price terms and these are expected to increase by 36% per
annum due to inflation during the five-year life of the machines.
Basril plc has a money cost of capital of 12% and taxation should be ignored.
Required:
(a)

(b)
(c)
(d)

Determine the best way for Basril plc to invest the available funds and calculate the
resultant NPV:
(i)
on the assumption that each of the three projects is divisible;
(ii) on the assumption that none of the projects are divisible.
(10 marks)
Explain how the NPV investment appraisal method is applied in situations where
capital is rationed.
(3 marks)
Discuss the reasons why capital rationing may arise.
(7 marks)
Discuss the meaning of the term relevant cash flows in the context of investment
appraisal, giving examples to illustrate your discussion.
(5 marks)
(25 marks)
(ACCA 2.4 Financial Management and Control December 2003 Q3)

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