- 10 Marks
FM – L2 – Q74 – Discounted Cash Flow
Question
TechNova Ltd
(a) TechNova Ltd, a software company, has developed a new game “Zestora” which it plans to launch in the near future. Sales volumes, production volumes, and selling prices for “Zestora” over its four-year life are expected to be as follows:
| Year | Sales and production (units) | Selling price (GH₵ per game) |
|---|---|---|
| 1 | 15,000 | 45 |
| 2 | 25,000 | 40 |
| 3 | 20,000 | 38 |
| 4 | 10,000 | 35 |
Financial information relating to the production of Zestora:
| Item | GH₵ per game |
|---|---|
| Direct materials | 6 |
| Direct labour | 8 |
| Variable production overheads | 4 |
Additional information:
- Annual fixed production overheads will be GH₵150,000.
- Initial investment in equipment will be GH₵800,000.
- Additional working capital of GH₵50,000 will be needed at the beginning of the project and will be released at the end of year four.
- Tax at the rate of 25% is payable on profits one year in arrears.
- Capital allowance is available at 25% per year on a reducing balance basis.
- TechNova Ltd’s cost of capital is 10%.
- The equipment will have no residual value at the end of year four.
Required: Calculate the net present value of the proposed investment and comment on your findings.
Answer
74 TechNova Ltd
(a) Workings
| Year 1 | Year 2 | Year 3 | Year 4 | |
|---|---|---|---|---|
| Sales units | 15,000 | 25,000 | 20,000 | 10,000 |
| GH₵ | GH₵ | GH₵ | GH₵ | |
| Selling price | 45 | 40 | 38 | 35 |
| Direct materials | 6 | 6 | 6 | 6 |
| Direct labour | 8 | 8 | 8 | 8 |
| Variable overheads | 4 | 4 | 4 | 4 |
| Contribution per unit | 27 | 22 | 20 | 17 |
| Total contribution | 405,000 | 550,000 | 400,000 | 170,000 |
| Fixed overheads | 150,000 | 150,000 | 150,000 | 150,000 |
| Cash profit | 255,000 | 400,000 | 250,000 | 20,000 |
Capital allowances
| Year 1 | Year 2 | Year 3 | Year 4 | |
|---|---|---|---|---|
| Cost/WDV | 800,000 | 600,000 | 450,000 | 337,500 |
| Capital allowance (25%) | 200,000 | 150,000 | 112,500 | 337,500 |
| WDV | 600,000 | 450,000 | 337,500 | 0 |
Taxable profit and tax
| Year 1 | Year 2 | Year 3 | Year 4 | |
|---|---|---|---|---|
| Cash profit | 255,000 | 400,000 | 250,000 | 20,000 |
| Capital allowance | 200,000 | 150,000 | 112,500 | 337,500 |
| Taxable profit | 55,000 | 250,000 | 137,500 | (317,500) |
| Tax @ 25% | 13,750 | 62,500 | 34,375 | (79,375) |
Net cash flows
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
|---|---|---|---|---|---|---|
| Equipment | (800,000) | |||||
| Working capital | (50,000) | 50,000 | ||||
| Cash profit | 255,000 | 400,000 | 250,000 | 20,000 | ||
| Tax | (13,750) | (62,500) | (34,375) | 79,375 | ||
| Net cash flow | (850,000) | 255,000 | 386,250 | 187,500 | 35,625 | 79,375 |
| Discount factor (10%) | 1.000 | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
| Present value | (850,000) | 231,795 | 319,043 | 140,813 | 24,332 | 49,292 |
NPV = GH₵(84,725)
Comment: The NPV of the project is negative, indicating that the project is not financially viable at a 10% cost of capital. TechNova Ltd should not proceed with the investment in Zestora, as it would reduce shareholder value. Alternative projects with positive NPVs should be considered, or the assumptions (e.g., sales volumes, costs, or selling prices) should be re-evaluated to improve the project’s viability.
- Topic: Taxation and Inflation
- Uploader: Samuel Duah