ACC208 TUTORIAL 5

1. Explain the significance of cost of capital. What factors determine a firm’s cost of capital?

2. Planning investments is same as capital budgeting. Why is capital budgeting an important

process and explain reasons errors could be costly.

3. What are sunk costs? When are they relevant to investment decisions?

4. Compare and contrast the two discounted cash flow techniques: Net Present Value (NPV)
and Internal Rate of Return (IRR) incorporating the advantages and disadvantages.

5. Central Mass Ambulance Service can purchase a new ambulance for $200,000 that will
provide an annual net cash flow of $50,000 per year for five years. The salvage value of the
ambulance will be $25,000. Assume the ambulance is sold at the end of year 5. Calculate the
NPV of the ambulance if the cost of capital is 9%.

6. Spoonfey Ltd is a manufacturer of cutlery. The firm’s managers have asked you to evaluate a
project proposal to diversify into manufacturing nailfiles. A new machine to mould the
plastic on to the end of the nailfiles would need to be purchased at a cost of $150 000. Freight
and insurance for the new machine will cost $3500 and installation will cost a further $1200.
The files would be pressed on existing equipment. The files would be produced by
introducing a night shift, so will not displace any current production capacity. The existing
machine would be modified at a cost of $20 000.

If the new project goes ahead, Spoonfey will need to increase the raw materials inventory by
$2500. The finished goods inventory would need to be $4500 higher than its current level.
Spoonfey will supply 30-day terms to the distributors of the nailfiles and this is expected to
result in an increase of $60 000 in accounts receivable. The increase in accounts receivable
will occur during the first week of production for the project. Spoonfey has arranged credit
with suppliers of the plastic that will be used in the production process. This is expected to
result in an increase of $15 000 to accounts payable.

Spoonfey Ltd has set a 5-year life for the proposed nailfile project. Spoonfey’s management
have given you the following forecasts of operating cash flows:
 Sales of nailfiles for the first year are $120 000. The estimated growth rate for sales is 2%
p.a. for the second and subsequent years of the project.
 Raw materials are estimated at 15% of sales.
 Labour costs for the project will be $30 000 per annum.
 Spoonfey’s annual electricity bill is $50 000. The electricity cost for the nailfile project is
expected to be 12% of sales.

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At the end of 5 years, Spoonfey will terminate the nailfile project. It is expected that the plastic
moulding machine that was purchased for the project will be sold for $30 000. Removal costs of
$650 are expected for the moulding machine. The modifications to the machine used for pressing
the metal part of the files will not affect the future use of that machine and will remain in place.
The increase in net working capital will be returned to the firm at the end of the project.

REQUIRED

(a) Construct a table of the annual cash flows for Spoonfey’s nailfile project.

(b) Calculate the NPV of the project using a discount rate of 12%.

(c) On the basis of the NPV, is the project acceptable? Why?

(d) Use Ms Excel to calculate the IRR and discuss whether project is acceptable on the basis
of IRR.

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