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Chapter 6

Capital investment decisions

Question 6.22
The evidence of many recent studies suggests that there are major differences
between current theories of investment appraisal and the methods which firms
actually use in evaluating long-term investments.

You are required to:


(a) present theoretical arguments for the choice of net present value as the best
method of investment appraisal;
(b) explain why in practice other methods of evaluating investment projects have
proved to be more popular with decision-makers than the net present value
method.

Question 6.23
Accounting rate of return and NPV calculations plus
a discussion of qualitative factors
The following information relates to three possible capital expenditure projects.
Because of capital rationing only one project can be accepted.

The company estimates its cost of capital is 18%.

Calculate
(a) The payback period for each project. (4 marks)
(b) The Accounting Rate of Return for each project. (4 marks)
(c) The Net present value of each project. (8 marks)
(d) Which project should be accepted give reasons. (5 marks)
(e) Explain the factors management would need to consider: in addition to the
financial factors before making a final decision on a project. (4 marks)
(Total 25 marks)

27 PART I: QUESTIONS
Question 6.24
Calculation of payback, NPV and ARR for mutually
exclusive projects
Your company is considering investing in its own transport fleet. The present position
is that carriage is contracted to an outside organization. The life of the transport
fleet would be five years, after which time the vehicles would have to be
disposed of.
The cost to your company of using the outside organization for its carriage needs
is 250 000 for this year. This cost, it is projected, will rise 10% per annum over the
life of the project. The initial cost of the transport fleet would be 750 000 and it is
estimated that the following costs would be incurred over the next five years:

Other costs include depreciation. It is projected that the fleet would be sold for
150 000 at the end of year 5. It has been agreed to depreciate the fleet on a straight
line basis.
To raise funds for the project your company is proposing to raise a long-term
loan at 12% interest rate per annum.
You are told that there is an alternative project that could be invested in using
the funds raised, which has the following projected results:

Payback=3 years
Accounting rate of return=30%
Net present value=140 000.

As funds are limited, investment can only be made in one project.


Note: The transport fleet would be purchased at the beginning of the project and
all other expenditure would be incurred at the end of each relevant year.

Required:
(a) Prepare a table showing the net cash savings to be made by the firm over the
life of the transport fleet project. (5 marks)
(b) Calculate the following for the transport fleet project:
(i) Payback period
(ii) Accounting rate of return
(iii) Net present value (13 marks)
(c) Write a short report to the Investment Manager in your company outlining
whether investment should be committed to the transport fleet or the
alternative project outlined. Clearly state the reasons for your decision.
(7 marks)
(Total 25 marks)

28 CAPITAL INVESTMENT DECISIONS


Question 6.25
NPV and payback calculations
You are employed as the assistant accountant in your company and you are currently
working on an appraisal of a project to purchase a new machine. The
machine will cost 55 000 and will have a useful life of three years. You have
already estimated the cash flows from the project and their taxation effect, and the
results of your estimates can be summarized as follows:

Year 1 Year 2 Year 3


Post-tax cash inflow 18 000 29 000 31 000

Your company uses a post-tax cost of capital of 8% to appraise all projects of


this type.

Task 1
(a) Calculate the net present value of the proposal to purchase the machine.
Ignore the effects of inflation and assume that all cash flows occur at the end of
the year.
(b) Calculate the payback period for the investment in the machine.
Task 2
The marketing director has asked you to let her know as soon as you have completed
your appraisal of the project. She has asked you to provide her with some
explanation of your calculations and of how taxation affects the proposal.
Prepare a memorandum to the marketing director which answers her queries.
Your memorandum should contain the following:
(a) your recommendation concerning the proposal;
(b) an explanation of the meaning of the net present value and the payback
period;
(c) an explanation of the effects of taxation on the cash flows arising from capital
expenditure.

Question 6.26
Present value of purchasing or renting machinery
The Portsmere Hospital operates its own laundry. Last year the laundry processed
120 000 kilograms of washing and this year the total is forecast to grow to 132 000
kilograms. This growth in laundry processed is forecast to continue at the same
percentage rate for the next seven years. Because of this, the hospital must immediately
replace its existing laundry equipment. Currently, it is considering two
options, the purchase of machine A or the rental of machine B. Information on both
options is given below:

29 PART I: QUESTIONS
Other information:
1. The hospital is able to call on an outside laundry if there is either a breakdown
or any other reason why the washing cannot be undertaken in-house. The
charge would be 10 per kilogram of washing.
2. Machine A, if purchased, would have to be paid for immediately. All other cash
flows can be assumed to occur at the end of the year.
3. Machine A will have no residual value at any time.
4. The existing laundry equipment could be sold for 10 000 cash.
5. The fixed costs are a direct cost of operating the laundry.
6. The hospitals discount rate for projects of this nature is 15%.

Task 1
You are an accounting technician employed by the Portsmere Hospital and you are
asked to write a brief report to its chief executive. Your report should:
(a) evaluate the two options for operating the laundry, using discounted cash flow
techniques;
(b) recommend the preferred option and identify one possible non-financial
benefit;
(c) justify your treatment of the 10 000 cash value of the existing equipment;
(d) explain what is meant by discounted cash flow.
Note:
Inflation can be ignored.

Question 6.27
Comparison of NPV and IRR and relationship
between profits and NPV
Khan Ltd is an importer of novelty products. The directors are considering
whether to introduce a new product, expected to have a very short economic life.
Two alternative methods of promoting the new product are available, details of
which are as follows:
Alternative 1 would involve heavy initial advertising and the employment of a
large number of agents. The directors expect that an immediate cash outflow of
100 000 would be required (the cost of advertising) which would produce a net
cash inflow after one year of 255 000. Agents commission, amounting to 157 500,
would have to be paid at the end of two years.
Alternative 2 would involve a lower outlay on advertising (50 000, payable
immediately), and no use of agents. It would produce net cash inflows of zero after
one year and 42 000 at the end of each of the subsequent two years.
Mr Court, a director of Khan Ltd, comments, I generally favour the payback
method for choosing between investment alternatives such as these. However, I
am worried that the advertising expenditure under the second alternative will
reduce our reported profit next year by an amount not compensated by any net
revenues from sale of the product in that year. For that reason I do not think we
should even consider the second alternative.
The cost of capital of Khan Ltd is 20% per annum. The directors do not expect
capital or any other resource to be in short supply during the next three years.

You are required to:


(a) calculate the net present values and estimate the internal rates of return of the
two methods of promoting the new product; (10 marks)
(b) advise the directors of Khan Ltd which, if either, method of promotion they
should adopt, explaining the reasons for your advice and noting any additional
information you think would be helpful in making the decision; (8 marks)
(c) comment on the views expressed by Mr Court. (7 marks)
Ignore taxation.
(Total 25 marks)

30 CAPITAL INVESTMENT DECISIONS


Question 6.28
NPV calculation and taxation
Data
Tilsley Ltd manufactures motor vehicle components. It is considering introducing a
new product. Helen Foster, the production director, has already prepared the following
projections for this proposal:

Helen Foster has recommended to the board that the project is not worthwhile
because the cumulative after tax profit over the four years is less than the capital
cost of the project.
As an assistant accountant at the company you have been asked by Philip
Knowles, the chief accountant, to carry out a full financial appraisal of the proposal.
He does not agree with Helen Fosters analysis, and provides you with the following
information:

the initial capital investment and working capital will be incurred at the beginning
of the first year. All other receipts and payments will occur at the end of each
year;
the equipment will cost 10 million;
additional working capital of 1 million;
this additional working capital will be recovered in full as cash at the end of the
four-year period;
the equipment will qualify for a 25% per annum reducing balance writing down
allowance;
any outstanding capital allowances at the end of the project can be claimed as a
balancing allowance;
at the end of the four-year period the equipment will be scrapped, with no
expected residual value;
the additional working capital required does not qualify for capital allowances,
nor is it an allowable expense in calculating taxable profit;
Tilsley Ltd pays corporation tax at 30% of chargeable profits;
there is a one-year delay in paying tax;
the companys cost of capital is 17%.

Task
Write a report to Philip Knowles. Your report should:
(a) evaluate the project using net present value techniques;
(b) recommend whether the project is worthwhile;
(c) explain how you have treated taxation in your appraisal;
(d) give three reasons why your analysis is different from that produced by Helen
Foster, the production director.

Notes:
Risk and inflation can be ignored.

31 PART I: QUESTIONS