- 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 | 13,300 | 21,280 | 26,600 | 13,300 | – |
| Fixed costs | (5,300) | (5,618) | (5,955) | (6,312) | – |
| Depreciation | (4,375) | (4,375) | (4,375) | (4,375) | – |
| Interest payments | (2,000) | (2,000) | (2,000) | (2,000) | – |
| Taxable profit | 1,625 | 9,287 | 14,270 | 613 | |
| Taxation | – | (488) | (2,786) | (4,281) | (184) |
| Profit after tax | 1,625 | 8,799 | 11,484 | (3,668) | (184) |
| Scrap value | – | – | – | 2,500 | – |
| After-tax cash flows | 1,625 | 8,799 | 11,484 | (1,168) | (184) |
| Discount at 10% | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
| Present values | 1,477 | 7,268 | 8,624 | (798) | (114) |
Net present value = (16,457,000 – 20,000,000) = ₦3,543,000 so reject the project. The following information was included with the draft investment appraisal:
(1) The initial investment is ₦20 million.
(2) Selling price: ₦120/unit (current price terms), selling price inflation is 5% per year.
(3) Variable cost: ₦70/unit (current price terms), variable cost inflation is 4% per year.
(4) Fixed overhead costs: ₦5,000,000/year (current price terms), fixed cost inflation is 6% per year.
(5) ₦2,000,000/year of the fixed costs are development costs that have already been incurred and are being recovered by an annual charges to the project.
(6) Investment financing is by a ₦20 million loan at a fixed interest rate of 10% per year.
(7) 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.
(8) The scrap value of machinery at the end of the four-year project is ₦2,500,000.
(9) The real weighted average cost of capital of Keke is 7% per year.
(10) 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)
Answer
a. Errors in the investment appraisal
- Contribution and fixed costs not adjusted for specific inflation rates (selling price 5%, variable 4%, fixed 6%).
- Development costs (₦2m/year) are sunk and should be excluded.
- Interest payments should not be included in cash flow appraisal (use WACC).
- Depreciation is accounting, not tax allowable; use 25% reducing balance tax depreciation.
- Tax paid in year of accrual, not one year in arrears.
- Scrap value tax not considered.
- Discount rate 10% incorrect; use real WACC 7%, or money WACC = 7% + 4.7% = 11.7%.
- Year 5 cash flow unnecessary (project 4 years).
- NPV calculation error in summation.
(4 Marks)
b. Revised NPV calculation
First, money terms cash flows.
Selling price inflation 5%, variable 4%, fixed 6%.
Year 1:
Sales units 250k, SP = 1201.05 = 126, VC = 701.04 = 72.8, Contribution/unit = 53.2, Total contrib = 13,300k
Fixed = 5m *1.06 = 5,300k
Tax dep: Initial 20m, year 1 dep 25% = 5m, TWDV 15m
Taxable = contrib – fixed – tax dep = 13,300 – 5,300 – 5,000 = 3,000k
Tax year 2 = 30% *3,000 = 900k
CF year 1 = contrib – fixed = 13,300 – 5,300 = 8,000k
Year 2:
Units 400k, SP 1261.05 = 132.3, VC 72.81.04 = 75.712, contrib/unit = 56.588, total 22,635k
Fixed 5,300*1.06 = 5,618k
Tax dep 25%*15m = 3,750k, TWDV 11,250k
Taxable = 22,635 – 5,618 – 3,750 = 13,267k
Tax year 3 = 3,980k
CF year 2 = 22,635 – 5,618 = 17,017k
Year 3:
Units 500k, SP 132.31.05 = 138.915, VC 75.7121.04 = 78.74, contrib/unit = 60.175, total 30,087.5k
Fixed 5,618*1.06 = 5,955k
Tax dep 25%*11.25m = 2,812.5k, TWDV 8,437.5k
Taxable = 30,087.5 – 5,955 – 2,812.5 = 21,320k
Tax year 4 = 6,396k
CF year 3 = 30,087.5 – 5,955 = 24,132.5k
Year 4:
Units 250k, SP 138.9151.05 = 145.861, VC 78.741.04 = 81.89, contrib/unit = 63.971, total 15,992.75k
Fixed 5,955*1.06 = 6,312k
Tax dep 25%*8.4375m = 2,109.375k, TWDV 6,328.125k
Taxable = 15,992.75 – 6,312 – 2,109.375 = 7,571.375k
Tax year 5 = 2,271k
CF year 4 = 15,992.75 – 6,312 = 9,680.75k + scrap 2,500k – tax on scrap.
Scrap 2,500k, TWDV 6,328.125k, balancing charge = 6,328.125 – 2,500 = 3,828.125k, tax year 5 + 30%*3,828.125 = 1,148k
So year 4 CF = 9,680.75 + 2,500 = 12,180.75k
Tax in arrears, so year 1 CF no tax, year 2 CF 17,017 – 900 = 16,117k
Year 3 CF 24,132.5 – 3,980 = 20,152.5k
Year 4 CF 12,180.75 – 6,396 = 5,784.75k
Year 5 tax 2,271 + 1,148 = 3,419k, but since project ends year 4, include in year 4 PV? No, tax year 5 is paid year 5, but project ends, so include.
The project is 4 years, scrap end year 4, tax on year 4 profit paid year 5, balancing tax year 5.
So cash flows:
Year 0: -20,000k
Year 1: 8,000k
Year 2: 16,117k
Year 3: 20,152.5k
Year 4: 5,784.75k – 3,419k = 2,365.75k ? No, year 4 CF before year 4 tax, year 4 tax paid year 5, so year 4 CF = 12,180.75k, year 5 = – (tax on year 4 + balancing) = -3,419k
Discount rate: money cost of capital = (1+0.07)(1+0.047) -1 = 0.1194 or 11.94%
PV year 1 = 8,000 / 1.1194 = 7,144
Year 2 = 16,117 / 1.1194^2 = 12,851
Year 3 = 20,152.5 / 1.1194^3 = 14,381
Year 4 = 12,180.75 / 1.1194^4 = 7,729
Year 5 = -3,419 / 1.1194^5 = -1,936
Total PV inflows = 7,144 + 12,851 + 14,381 + 7,729 – 1,936 = 40,169
NPV = 40,169 – 20,000 = 20,169k Accept the project.
(12 Marks)
c. Problems and solutions
i. Multiple IRR: Non-conventional cash flows (sign changes) lead to multiple IRRs, confusing which to use.
Overcome: Use NPV instead, as it is more reliable; or modified IRR.
ii. Different business risk: Standard discount rate may not reflect higher/lower risk.
Overcome: Use risk-adjusted discount rate; sensitivity analysis; or real options.
(4 Marks)
- Topic: Investment Appraisal Techniques
- Series: MAY 2024
- Uploader: Samuel Duah