- 20 Marks
Question
The following draft appraisal of a proposed investment project has been prepared for the Finance Director of Keke Plc (KP) by a trainee accountant. The project is consistent with the current business operations of KP.
| Year | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| Sales (units/yr) | 250,000 | 400,000 | 500,000 | 250,000 | |
| Contribution (₦000) | 13,300 | 21,280 | 26,600 | 13,300 | – |
| Fixed costs (₦000) | (5,300) | (5,618) | (5,955) | (6,312) | – |
| Depreciation (₦000) | (4,375) | (4,375) | (4,375) | (4,375) | – |
| Interest payments (₦000) | (2,000) | (2,000) | (2,000) | (2,000) | – |
| Taxable profit (₦000) | 1,625 | 9,287 | 14,270 | 613 | |
| Taxation (₦000) | – | (488) | (2,786) | (4,281) | (184) |
| Profit after tax (₦000) | 1,625 | 8,799 | 11,484 | (3,668) | (184) |
| Scrap value (₦000) | – | – | – | 2,500 | – |
| After-tax cash flows (₦000) | 1,625 | 8,799 | 11,484 | (1,168) | (184) |
| Discount at 10% | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
| Present values (₦000) | 1,477 | 7,268 | 8,624 | (798) | (114) |
Net present value = (16,457,000 – 20,000,000) = ₦3,543,000, so reject the project.
Additional Information:
- The initial investment is ₦20 million.
- Selling price: ₦120/unit (current price terms), selling price inflation is 5% per year.
- Variable cost: ₦70/unit (current price terms), variable cost inflation is 4% per year.
- Fixed overhead costs: ₦5,000,000/year (current price terms), fixed cost inflation is 6% per year.
- ₦2,000,000/year of the fixed costs are development costs that have already been incurred and are being recovered by annual charges to the project.
- Investment financing is by a ₦20 million loan at a fixed interest rate of 10% per year.
- Keke Plc can claim 25% reducing balance tax allowable depreciation 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 ₦2,500,000.
- The real weighted average cost of capital of Keke is 7% per year.
- The general rate of inflation is expected to be 4.7% per year.
Required:
a. Identify and comment on any errors in the investment appraisal prepared by the trainee accountant.
(4 Marks)
b. Prepare a revised calculation of the net present value of the proposed investment project and comment on the project’s acceptability.
(12 Marks)
c. Discuss the problems faced when undertaking investment appraisal in the following areas and comment on how these problems can be overcome:
i. An investment project has several internal rates of return;
ii. The business risk of an investment project is significantly different from the business risk of current operations.
(4 Marks)
(Total: 20 Marks)
Answer
a) Errors in the Original Investment Appraisal
- Incorrect Application of Inflation: The inflation adjustment for selling prices and variable costs in calculating contribution was not correctly applied; only one year’s inflation was used for each year’s operation.
- Inclusion of Irrelevant Fixed Costs: ₦2,000,000 per year in development costs, already incurred, was included, which is irrelevant to the decision-making process.
- Incorrect Depreciation Method: Straight-line accounting depreciation was used instead of the tax-allowable 25% reducing balance method.
- Inclusion of Interest Payments: Interest payments were included, though these should have been accounted for by the discount rate.
- Incorrect Discount Rate Used: The interest rate on debt finance was incorrectly used as the discount rate instead of the nominal weighted average cost of capital.
(c) Problems in Investment Appraisal
i. Multiple Internal Rates of Return (IRR):
- When an investment has unconventional cash flows that change sign, multiple IRRs may exist, making the IRR method less reliable. The Net Present Value (NPV) method is recommended as it effectively accommodates non-standard cash flows.
ii. Different Business Risk Levels:
- If a project’s business risk differs significantly from current operations, using the company’s WACC as the discount rate may be inappropriate. In such cases, the Capital Asset Pricing Model (CAPM) can determine a project-specific discount rate that reflects the project’s systematic risk
- Topic: Investment Appraisal Techniques
- Series: MAY 2024
- Uploader: Dotse