ADVANCED CAPITAL BUDGETING

PRACTICE QUESTIONS

Question 1

You have been recently approached by an executive in a company that is

considering investing $4.5m in a project to achieve an annual increase in revenues
over the next five years of $2m. The project will lead to an increase in wage costs of

$0.4m p.a and will also require expenditure $0.3 m p.a to maintain the level of

existing assets to be used on the project. Additional investment in working capital

equivalent to 10% of the increase in revenue will need to be in place at the start of

each year. An analyst from your country’s statistical office has also provided you with

the following forecasts of the rates of inflation each year for the next five years:

Revenues 10%

Wages 5%

Assets 7%

General Prices 6.5%

The real cost of capital of the company is 8%. All cash-flows are in real terms, ignore
taxation.

Find the free cash-flows of the firm and determine whether it is viable [15-marks]

Question 2

A tour operator based in Victoria Falls intends to take advantage of the duty free legislation
that has been recently announced by the Government of Zimbabwe on the importation of
duty free goods specifically for the tourism industry. You are seconded to assist in the
evaluation of the tax advantages which are likely to accrue to the organisation as a result of

the acquisition.

The 68-seater bus to be purchased to ferry tourists to and from the scenic areas around
Victoria Falls will cost $26 000. The bus will have a useful life of 3-years and will be disposed
of on the final day of year 3. Tax is payable at 30% and capital allowances are available at

25% on a reducing balance method.

i. Calculate the writing down allowances for the bus and hence the tax savings each
year if the proceeds on disposal of the asset are expected to be $12 500

ii. If net trading income is expected to be $16 000 p.a and the cost of capital is 8%,
calculate the free cash flows and hence the NPV of the project and advise.

Question 3

$500,000 is to be borrowed for 3 years and repaid in equal instalments. The risk­free rate is

6% and all debt is assumed to be risk free. Calculate the present value of the tax relief on
the debt interest if the corporation tax rate is 30%. Assume that tax is delayed 1 year.

Question 4

Garwe foods plc is considering diversifying its operations away from it main area of business
(food processing) into plastics and packaging. It wishes to evaluate an investment project,
which involves the purchase of a moulding machine that costs $450 000. The project is
expected to produce net annual operating cash flows of $220 000 for each of the three years

of its life. At the end of this time its scrap value will be zero.

The assets of the project will support debt finance of 40% of its initial cost (including issues
costs). The loan is to be repaid in three equal annual instalments. The balance of finance will

be provided by placing of new equity. Issue costs will be 5% of funds raised for the equity
placing and 2% for the loan. Debt issue costs are allowable for corporate tax.

The plastic industry has an average equity beta of1.368 and an average debt : equity ratio of
1: 5 at market values. Garwe’s current equity beta is 1.8 and 20% of its long term capital is

represented by debt which is generally regarded to be risk free.

The risk­free rate is 10% pa and the expected return on an average market portfolio is 15%.
Corporate tax rate is at a rate of 30%, payable in the same year. The machine will attract a

70% initial capital allowance and the balance is to be written off evenly over the remainder of
the asset life and is allowable against tax. The firm is certain it will earn sufficient profits

against which to offset these allowances.

Calculate the APV and determine whether the the project is worth investing in

Question 5

A upcoming insurance company has estimated that the expected value of its portfolio in two

weeks time will be $50-million, with a standard deviation of $4.85 million.

Using a 95% confidence level, identify the value at risk.

Question 6

An upcoming online retailer who intends to take advantage of the rural market and make use
of computers donated by HE, is considering investing $2m on improving its customer

information and online ordering systems. This is justified on the grounds that it will allow the
business to extend the range of products offered. In particular the board are interested in
selling enabling gadgets and have estimated the following:

Timing 1-years time

Estimated Cost $5m

Present Value of net receipts $4m

Volatility of CF 40%

Risk free rate 5%

Advise the firm

Question 7

Evaluate the relevance of the BSM model in real option valuation in capital budgeting
Question 8

International capital budgeting

Question 9

Sources of finance in international investment analysis

Question 10

Capital budgeting techniques use in the developing world in general and in Zimbabwe in
particular

Question 11

SME’s in the manufacturing sector. How they can be financed for capital investments.

Question 12

Build Operate and transfer method of financing capital projects (Case Study). Evaluation of
appropriateness in Zimbabwe

Question 13

You have been recently appointed to the post of senior finance officer in the ministry of local
government and public works. You have however discovered that the road infrastructure in
rural Zimbabwe is in a dilapidated state and needs to be upgraded so as to enhance
accessibility.

i. How do you think you will raise funds to fund such projects

ii. What are some of the indicators you think your financiers may require from a person

of your calibre so that they can be convinced to release the funds?

Question 14

Evaluate the relevance of social impact bonds in funding such projects as hospital
construction in a country like Zimbabwe.

Or
What are social impact bonds and how can they be used in a country like Zimbabwe

Question 15

i. Is real options analysis a special case of discounted cash flow analysis, or is discounted cash
flow analysis a special case of real options analysis?
ii. Explain what a risk-neutral probability means.
iii. What is the difference between a recombining lattice and a non-recombining lattice?

Question 16
Why should capital budgeting for subsidiary projects be assessed from the parent’s
perspective? What additional factors that normally are not relevant for a purely domestic
project deserve consideration in multinational capital budgeting?

Question 17

i. Describe in general terms how future appreciation of the euro will likely affect the
value (from the parent’s perspective) of a project established in Germany today
by a U.S.-based MNC. Will the sensitivity of the project value be affected by the
percentage of earnings remitted to the parent each year?
ii. Repeat 17.i above, but assume the future depreciation of the euro.

Question 18

Brower, Inc. just constructed a manufacturing plant in Ghana. The construction cost 9 billion
Ghanian cedi. Brower intends to leave the plant open for 3 years. During the 3 years of
operation, cedi cash flows are expected to be 3 billion cedi, 3 billion cedi, and 2 billion cedi,
respectively. Operating cash flows will begin one year from today and are remitted back to
the parent at the end of each year. At the end of the third year, Brower expects to sell the
plant for 5 billion cedi. Brower has a required rate of return of 17 percent. It currently takes
8,700 cedi to buy one U.S. dollar and the cedi is expected to depreciate by 5 percent per
year.
i. Determine the NPV for this project. Should Brower build the plant?
ii. How would your answer change if the value of the cedi was expected to remain
unchanged from its current value of 8,700 cedi per U.S. dollar over the course of
the 3 years? Should Brower construct the plant then?

Question 19
i. Blocked funds analysis plus every other area looked @
ii. Sustainable funding mechanisms for the Chirundu Beitbridge Highway, Mutange
Dam project, Zambezi River Project and Sengwa Thermal Power plant….