Subject (SQ): FINANCIAL MANAGEMENT

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  • 20 Marks

FM – L2 – Q79 – Discounted Cash Flow

Calculate NPV for three investment projects with varying cash flows and discount rates for Zenith Solutions Ltd.

The Board of Zenith Solutions Ltd is considering the company’s capital investment options for the coming year, and also evaluating the following potential investments:

Investment A
This investment is similar to its current investments and requires an investment of GH₵60,000 now, GH₵40,000 for new capital equipment and GH₵20,000 for increases in working capital. This will be financed from Shareholders Funds. Sales next year would be 10,000 units, variable costs would be GH₵6 and the product would be sold for GH₵10. But due to entry of new competitors and technological improvements, the sales price would decline by 20% per annum thereafter, sales volume would fall by 10% and variable costs would fall by 20% per annum. Overheads attributed to the project would be GH₵15,000 per annum.
In year three the project would be wound up, working capital investment would be recovered and capital equipment sold off for 25% of its purchase costs the following year. Fixed costs include an annual charge of GH₵4,000 for depreciation.

Investment B
This is a long-term project in a totally new area, involving an immediate outlay of GH₵90,000, which they intend to borrow from their lenders at 6%. They expect net profits of GH₵12,000 next year, rising thereafter by 3% per annum in perpetuity.

Investment C
This is another long-term investment in a totally new area, involving an immediate outlay of GH₵25,000 which they intend financing by retained earnings. Expected annual net cash profits are as follows:
Years 1 to 4: GH₵3,000
Years 5 to 7: GH₵5,000
Year 8 onwards forever: GH₵7,000
The company discounts all projects lasting ten years duration or less at a cost of capital of 10% and all other projects at a cost of 13%. You may ignore taxation.

Required:
(a) Calculate the NPV of each project.

(b) Calculate the IRR of investments A and B (you may use 25% as the upper limit if you wish) and comment accordingly.

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  • 12 Marks

FM – L2 – Q78 – Discounted cash flow

Calculate NPV for Woodland Enterprises' new product investment with inflation and advise on project viability.

Woodland Enterprises plans to invest GH₵7 million in a new product. Net contribution over the next five years is expected to be GH₵4.2 million per annum in real terms. Marketing expenditure of GH₵1.4m per annum will also be needed. Expenditure of GH₵1.3m per annum will be required to replace existing assets which will now be used on the project but are getting to the end of their useful lives. This expenditure will be incurred at the beginning of each year. Additional investment in working capital equivalent to 10% of contribution will need to be in place at the start of each year. Working capital will be released at the end of the project. The following forecasts are made of the rates of inflation each year for the next five years:

Contribution Marketing Assets General prices
8% 3% 4% 4.70%

The real cost of capital of the company is 6%. All cash flows are in real terms. Ignore tax.

Required:
Calculate the net present value of the project and appraise whether it is a worthwhile project.

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  • 20 Marks

FM – L2 – Q76 – Investment Appraisal

Describe four differences in investment appraisal approaches between a municipal assembly and a mining company.

(A) Describe FOUR (4) ways in which the investment appraisal approach of a City Council will differ from a GoldPeak Ltd, a mining company.

(B) StarPrint Ltd has been printing all its magazines from a facility in Abu Dhabi due to cost advantages. The company is considering establishing its own printing department, and the R&D team has identified a printing machine that meets the quality and cost specifications of StarPrint Ltd. The machine also has the capacity to print to meet the market needs of the company. The machine, which has a useful life of 5 years, will cost GH₵800,000, and immediate installation cost will be GH₵50,000. Fixed cost for maintaining the machine will be GH₵170,000 per annum over the machine’s useful life, and additional working capital of GH₵30,000 will be introduced in year 2. The use of this machine will generate a contribution of GH₵500,000 per annum for five (5) years. Corporate income tax rate, payable in arrears, is 25%, and the company’s after-tax cost of capital is 20%. No capital allowance is permitted.

Required:
Calculate the NPV for the project and advise management on whether to accept or reject the project.

(C) Explain the following types of contracts:

(i) Mudaraba contract

(ii) Musharaka contract

(iii) Murabaha contract

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  • 10 Marks

FM – L2 – Q75 – Discounted cash flow

Calculate NPV to decide between maintaining old equipment or buying new equipment for Wisdom Ltd, using a 20% cost of capital.

The maintenance manager of Wisdom Ltd insists that management should maintain an old piece of equipment that had been used for 5 years and is fully depreciated rather than buy a new one. The old equipment has a current operating cost of GH₵53,000.00 per annum. The operating cost of the equipment is expected to increase at 5% every year over the next four years, with a sale value of GH₵6,500.00 in the fifth year.

The maintenance manager has proposed that a new system with enhanced technology to reduce operating cost to GH₵32,000.00 for the next three years and GH₵33,600.00 for the fourth and fifth years be introduced. The new equipment will cost GH₵60,000.00 and when introduced, a redundancy cost of GH₵25,000.00 will be paid, with the old equipment sold for GH₵12,000.00. The sale value of the new equipment will be GH₵10,200.00 after its five years’ useful life.

Required:

Using net present value (NPV) method of capital appraisal with 20% cost of capital, advise management on which option Wisdom Ltd should go for.

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  • 10 Marks

FM – L2 – Q74 – Discounted Cash Flow

Calculate NPV for TechNova Ltd's new game Zestora, considering sales, costs, and tax over four years.

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.

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  • 10 Marks

FM – L2 – Q73 – Discounted Cash Flow

Calculate the breakeven rate of return for Kofi's taxi service project using NPV criteria with given cash flows and costs.

Kofi, after his National Service and with no hope of securing a job in the formal sector, has decided to run a taxi service. The following have been made for the operation of a service between Asikrom and Sunyasi:
(i) Revenue totalling GH¢300 a week for 52 weeks in a year. This is net of fuel and other variable costs.
(ii) Tyres; four pieces for a year at GH¢120 per unit.
(iii) Maintenance and servicing; GH¢120 per month.
(iv) Salaries GH¢3,000 per year.
(v) Insurance GH¢350 per year.
The net cash flow will increase at 5% per annum for the next five years due to inflation. The cost of the vehicle is estimated at GH¢28,000. The project appears quite profitable based on the NPV criteria using the Government policy rate of 26%. However, the banks are offering rates far higher than the policy rate.

Required:
Calculate the breakeven rate of return for the project.

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  • 15 Marks

FM – L2 – Q72 – Discounted cash flow

Calculate NPV for two machines with given cash flows, tax, and capital allowances.

72 NANTWI PLC
The directors of Nantwi Plc are meeting to decide about the replacement of a machine. The existing machine has to be replaced soon, and there is a choice of two machines that could be purchased to replace it. These are Machine A and a larger Machine, B. The following information is available about each machine:

Machine A Machine B
Expected working life 4 years 5 years
Initial cost GH₵600,000 GH₵750,000
Residual value GH₵0 GH₵0
Working capital requirement GH₵100,000 GH₵200,000

The forecast pre-tax cash flows that will be earned using each machine are as follows:

Year 1 Year 2 Year 3 Year 4 Year 5
GH₵000 GH₵000 GH₵000 GH₵000 GH₵000
Machine A 470 520 490 450
Machine B 580 640 500 500 400

Nantwi Plc uses 10% as its cost of capital for capital expenditure evaluation.
Taxation at 30% is payable one year in arrears. Capital allowances are available at the rate of 25% each year on the reducing balance method. Inflation should be ignored.

Required
(a) Calculate the NPV with each of the machines.

(b) Calculate the payback period for each machine.

(c) Recommend with reasons which machine should be purchased.

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  • 20 Marks

FM – L2 – Q71 – Discounted Cash Flow

Calculate NPV for a project with GH₵3M equipment cost, 5-year cash flows, and 8% cost of capital, ignoring inflation and taxation.

A company, Zenith Innovations Ltd, is considering an investment in a new project to manufacture and sell a new product with a five-year lifespan. The project requires an investment of GH₵3 million in equipment. The residual value of this equipment after five years will be 30% of its original cost.

The estimates of net cash flows from operations in each year of the project are as follows:

Year Net Cash Flow (GH₵)
1 400,000
2 800,000
3 800,000
4 700,000
5 400,000

These cash flows are based on estimates that the annual increase in cash spending on fixed costs will be GH₵200,000, and the contribution/sales ratio from transactions will be 40%. The company’s cost of capital is 8%.

The management of Zenith Innovations Ltd is aware that actual cash flows could be higher or lower than expected, and sensitivity analysis should be carried out to establish the extent to which costs or revenues could differ from the estimate before the project ceases to have a positive NPV.

The investment in working capital will be minimal. Inflation and taxation should be ignored.

Required
(a) Calculate the net present value of the project.

(b) Carry out sensitivity analysis on the following items:

(i) The cost of the equipment, assuming that the residual value will be 30% of cost.

(ii) The residual value of the equipment.

(iii) Sales revenue.

(iv) Variable costs.

(v) Annual fixed costs.

(c) Comment on the risk in undertaking this project.

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  • 10 Marks

FM – L2 – Q70 – DCF: Risk and uncertainty

Calculate the expected NPV of a project with uncertain cash inflows affected by multiple probabilistic factors, using a 10% cost of capital.

A company is considering whether or not to invest in a project where the investment would be GH¢5,250,000. The project would have a five-year life, and estimated annual cash flows are as follows:

Year Cash inflows Cash outflows
GH¢ GH¢
1 3,000,000 1,500,000
2 4,000,000 1,800,000
3 5,000,000 2,400,000
4 4,000,000 1,700,000
5 3,000,000 1,000,000

The cost of capital is 10%.
The estimates of cash outflows are considered fairly reliable. However, the estimates of cash inflows are much more uncertain. Several factors could make the annual cash flows higher or lower than expected.
Factor 1: There is a 20% probability that government measures to control the industry will reduce annual cash inflows by 20%.
Factor 2: There is a 30% probability that another competitor will also enter the market: this would reduce the estimated cash inflows by 10%.
Factor 3: There is a 40% probability that demand will be stronger than expected. The company would not be able to supply more products to the market, but it would be able to sell at higher prices and cash inflows would be 5% higher than estimated.
Required
Calculate the expected net present value of the project.

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  • 20 Marks

FM – L2 – Q69 – Discounted cash flow

Calculate NPV of replacing Product X with Product Y using DCF analysis, with given sales, costs, and 8% cost of capital.

A well-established company in the region of the Volta River manufactures engines. One of its current products is Product X, for which sales will be 150,000 units in the year just ending (Year 1). However, after four more years, at the end of Year 5, Product X will no longer be permitted, when new government environmental regulations come into force. On or before that time, the company needs to introduce a new product to replace Product X.
A replacement product has already been developed. This is Product Y. A market research report has estimated that, if Product Y is introduced to the market now to replace Product X, annual sales of Product Y at a unit price of GH₵350 would be:

Annual sales (units) Probability
100,000 0.2
80,000 0.5
50,000 0.3

The current selling price of Product X is GH₵250 per unit, and its variable cost of sales is GH₵180. There is no possibility of increasing the selling price.
The annual sales demand for Product X is expected to fall each year if it is kept on the market. The best estimate is that annual sales in Year 2 will be 10,000 units less than in Year 1, with a further fall in sales by 10,000 units each year until Year 5.
To prepare a production facility for manufacturing Product Y instead of Product X, an initial capital outlay of GH₵2,000,000 would be required. Annual fixed costs would increase by GH₵160,000. The variable cost of making and selling Product Y would be GH₵230 per unit.
The company’s cost of capital is 8%. Ignore inflation and taxation.

Required:
(a) Using DCF analysis, calculate the NPV of a proposal to replace Product X with Product Y from Year 2 onwards.

(b) Estimate the minimum annual sales for Product Y that would be required to justify the immediate replacement of Product X with Product Y. Assume that the estimates of annual sales of Product X are correct.

(c) Calculate the minimum reduction in the annual sales of Product X, in Year 2 and in each subsequent year that would be necessary before you recommended the immediate replacement of Product X with Product Y. Assume that the estimates of annual sales of Product Y are correct.

(d) List briefly the weaknesses or limitations in the financial analysis in part (a) to (c) above.

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