Subject (SQ): FINANCIAL MANAGEMENT

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  • 16 Marks

FM – L2 – Q68 – Discounted Cash Flow

Calculate the expected NPV of a new product launch for Accra Nova Cosmetics Limited with given cash flows and a 12% cost of capital.

Accra Nova Cosmetics Limited has designed a new product that it would like to introduce to the market. It has spent GH¢250,000 on the design work so far. A market research report has indicated that the product will have a life of four years, and at a selling price of GH¢35 per unit, annual sales would be as follows:

Year Sales (units)
1 40,000
2 60,000
3 60,000
4 20,000

It has been estimated that to produce the new product, annual fixed production costs (all cash flows) will increase by GH¢200,000, and the variable cost per unit will be GH¢10.
Other cash flows for the project will be:

  • Capital expenditure of GH¢1,400,000 at the beginning of the project. There will be a residual value of GH¢600,000 from this investment at the end of Year 4.
  • An investment of GH¢400,000 will be required in working capital. This will be recovered at the end of Year 4.
  • Expenditure on advertising will be required, as follows:

Year Advertising costs
0 800,000
1 600,000
2 400,000
3 200,000

Required
(a) Calculate the expected NPV of the project to launch the new product, if the company’s cost of capital is 12%.

(b) Calculate the target cost for the product that is needed to achieve a return of 12% on investment and calculate the size of the current cost gap.

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  • 20 Marks

FM – L2 – Q67 – Capital rationing

Determine optimal investment for Yebson Plc with GH₵800,000, assuming divisible/indivisible projects, and calculate NPV

Yebson Plc is reviewing investment proposals that have been submitted by divisional managers. The investment funds of the company are limited to GH₵800,000 in the current year. Details of three possible investments, none of which can be delayed, are given below.

Project 1
An investment of GH₵300,000 in work station assessments. Each assessment would be on an individual employee basis and would lead to savings in labour costs from increased efficiency and from reduced absenteeism due to work-related illness. Savings in labour costs from these assessments in money terms are expected to be as follows:

Year 1 2 3 4 5
Cash flows (GH₵000) 85 90 95 100 95

Project 2
An investment of GH₵450,000 in individual workstations for staff that is expected to reduce administration costs by GH₵140,800 per annum in money terms for the next five years.

Project 3
An investment of GH₵400,000 in new ticket machines. Net cash savings of GH₵120,000 per annum are expected in current price terms and these are expected to increase by 3.6% per annum due to inflation during the five-year life of the machines.

Yebson Plc has a money cost of capital of 12% and taxation should be ignored.

Required:
(a) Determine the best way for Yebson Plc to invest the available funds and calculate the resultant NPV:
(i) on the assumption that each of the three projects is divisible
(ii) on the assumption that none of the projects are divisible.

(b) Explain how the NPV investment appraisal method is applied in situations where capital is rationed.

(c) Discuss the reasons why capital rationing may arise.

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  • 15 Marks

FM – L2 – Q66 – Capital rationing

Recommend investments to maximize NPV assuming divisible projects with a GH¢150,000 capital limit.

A company, Kumasi Ventures Ltd, has identified five investment projects that it would like to undertake. None of the investments can be delayed. If they are not undertaken now, the opportunity to invest will be lost. Details of the five investments are as follows:

Investment Capital investment required in Year 0 NPV of the investment
GH¢ GH¢
A 60,000 12,000
B 80,000 21,600
C 50,000 8,500
D 45,000 10,800
E 55,000 9,900

Capital is in short supply, and only GH¢150,000 is available for investment. The company cannot therefore undertake all five investments.
Required:
In order to maximise the total NPV of its investments, recommend which investments to undertake:
(a) assuming that all five investment projects are divisible.

(b) assuming that none of the five investments is divisible, and the choice is either 0% or 100% of each investment.

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  • 16 Marks

FM – L2 – Q65 – DCF: Specific applications

Calculate the equivalent annual cost for replacing a machine every 1, 2, 3, and 4 years and recommend the optimal replacement policy.

A business entity, Volta Ventures, is considering its policy for the replacement of machines. One type of machine in regular use is Machine Y. This machine has a maximum useful life of four years, but maintenance costs and other running costs rise with use. An estimate of costs and disposal values is as follows:

Machine Y: Purchase cost GH₵40,000

Year Maintenance costs and other running costs in the year Disposal value at the end of the year
GH₵ GH₵
1 8,000 25,000
2 12,000 20,000
3 20,000 10,000
4 25,000 0

The cost of capital is 10%.

Required
Calculate the equivalent annual cost of a replacement policy for the machine of replacement:
(a) every one year
(b) every two years
(c) every three years
(d) every four years.
Recommend a replacement policy for the machine.

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  • 12 Marks

FM – L2 – Q64 – DCF: Specific applications

Evaluate whether to acquire a machine and recommend purchase or lease, considering NPV with tax and capital allowances.

NexGen Enterprises is considering whether to acquire a new machine. The machine has a purchase cost of GH₵30,000, an expected useful life of five years, and a disposal value of GH₵6,000 at the end of year 5. The machine would generate additional cash flows of GH₵10,000 in each of its five years.
Two methods of financing are under consideration:
(i) To buy the machine with money obtained from a bank loan, at an interest rate of 8% after tax.
(ii) To lease the machine. The lease payments to the lessor would be GH₵7,000 at the end of each of the next five years.
The company’s cost of capital is 10% after tax.
Corporation tax is 30%. If the machine is purchased, the company will be able to claim capital allowances (tax depreciation allowances) of 25% each year on a reducing balance basis. Tax is payable at the end of the year following the year against profits earned during Year 1.

Required:
(a) Recommend whether the machine should be acquired.
(b) If your recommendation is to acquire the machine, recommend whether it should be purchased or leased.

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  • 20 Marks

FM – L2 – Q63 – DCF: Risk and uncertainty

Calculate NPV for two machines under different sales demand levels for Kofi Enterprises Ltd.

Kofi Enterprises Ltd must purchase a new machine for making a new product. There is a choice between two machines, Machine A and Machine B. Each machine has an estimated life of three years with no expected scrap value.
Machine A costs N₦15,000 and Machine B costs N₦20,000.
The variable costs of manufacture would be N₦1 per unit if Machine A is used and N₦0.50 per unit if Machine B is used. The product will sell for N₦4 per unit.
The demand for the product is uncertain. Following some market research, the following estimates of annual sales demand have been made:

Annual demand (Units) Probability
2,000 0.2
3,000 0.6
5,000 0.2

The sales demand in each year will be the same. For example, if the demand is 2,000 units in Year 1, it will be 2,000 units for every year of the project.
Taxation and fixed costs will be unaffected by any decision made.
Kofi Enterprises Ltd’s cost of capital is 6%.

Required:
(a) Calculate the NPV for each of investment options, Machine A and Machine B, for each of the possible levels of sales demand.

(b) Calculate the expected NPV for each of the investment options.

(c) Assume now that the decision is taken to buy Machine A.

(i) Calculate the probability that the NPV of the project will be negative.

(ii) Calculate the minimum annual sales required for the NPV of the project to be positive.

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  • 21 Marks

FM – L2 – Q62 – Discounted cash flow

Calculate contribution PV for two strategies and evaluate machine investment using IRR for Volta Fabrication Ltd.

DOME FABRICATION LIMITED
(a) Contribution
Strategy 1

Year 1 2 3 4 5
Demand (units) 10,000 12,000 15,000 18,000 20,000
Selling price (unit) GH¢25 GH¢25 GH¢25 GH¢25 GH¢25
Variable cost (unit) GH¢15 GH¢15 GH¢15 GH¢15 GH¢15
Contribution (unit)
Inflated contribution
Total contribution (GH¢)

10% discount factors
PV of contribution (GH¢)

Total PV of Strategy 1 contributions =

Strategy 2

Year 1 2 3 4 5
Demand (units) 12,000 14,000daf 16,000 18,000 20,000
Selling price (unit) GH¢22 GH¢22 GH¢22 GH¢22 GH¢22
Variable cost (unit) GH¢12 GH¢12 GH¢12 GH¢12 GH¢12
Contribution (unit)
Inflated contribution
Total contribution
Total contribution
PV of contribution (GH¢)

Total PV of strategy 2 contributions =

Strategy 2 is preferred as it has the higher present value of contributions.

(b) Evaluating the investment in the new machine using internal rate of return

Year 1 2 3 4 5
Total contribution
Fixed costs
Profit
10% discount factors
Present value
20% discount factors
Present value of profits

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  • 15 Marks

FM – L2 – Q61 – Discounted Cash Flow

Calculate NPV for Coastline Plc's project with equipment purchase, considering inflation and taxation.

Coastline Plc is considering whether to invest in a project whose details are as follows.
The project will involve the purchase of equipment costing GH¢2,000,000. The equipment will be used to produce a range of products for which the following estimates have been made.

Year Average unit sales price Average unit variable cost Incremental fixed costs Sales volume (units)
1 GH¢73.55 GH¢50 GH¢1,200,000 65,000
2 GH¢76.03 GH¢45 GH¢1,200,000 110,000
3 GH¢76.68 GH¢45 GH¢1,200,000 125,000
4 GH¢81.86 GH¢45 GH¢1,200,000 80,000

The sales prices allow for expected price increases over the period. However, cost estimates are based on current costs and do not allow for expected increases in costs. Inflation is expected to be 3% per year for variable costs and 4% per year for fixed costs. The incremental fixed costs are all cash expenditure.
Tax on profits is at the rate of 30%, and tax is payable in the same year.
The cost of capital is 10%.

Required:
Calculate the NPV of the project.

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  • 12 Marks

FM – L2 – Q60 – Discounted Cash Flow

Calculate NPV of ZQR Ltd's project ignoring inflation, with given cash flows and 10% cost of capital

ZQR Ltd, a manufacturing company, is considering a proposal to invest in machinery that it will use to increase its output and sales by 10,000 units in each of the next five years. The full purchase cost of the machinery would be GH¢225,000. This price includes a payment of GH¢20,000 made 12 months ago to the machinery supplier for a non-refundable down-payment for purchase of the machinery.

The company currently makes and sells a single product. This has a selling price of GH¢15 per unit and at present-day prices the direct costs per unit are GH¢3.75 for material and GH¢2.50 for labour. Incremental production overheads (all cash expenses) would be GH¢37,500 in each year, at current price levels.

Assume that all cash flows occur at the end of the year to which they relate.

ZQR’s cost of capital is 10%.

Required

(a) Calculate the NPV of the project, ignoring inflation.

(b) Calculate the NPV of the project, at a cost of capital of 10%, taking the following inflationary increases in revenues and costs into consideration:

Because of inflation, selling prices will rise by 7% in each year.

Material costs will rise by 5% each year, labour costs by 6% each year and overheads by 2% each year.

Comment on the differences in your results, compared with the NPV you calculated in part (a)

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  • 12 Marks

FM – L2 – Q59 – Discounted Cash Flow

Calculate NPV of a project by Zenith Ltd, ignoring and including inflation effects.

ZENITH LTD
(a) Calculate the NPV of an investment with the following estimated cash flows, assuming a cost of capital of 8%:

Years Annual cash flow
0 (3,000,000)
1–4 500,000
5–8 400,000
9–10 300,000
11 onwards 100,000

ZENITH LTD
(b) The cash flows for an investment project have been estimated at current prices, as follows:

Year Equipment Revenue Running costs
0 (900,000)
1 800,000 (400,000)
2 800,000 (350,000)
3 400,000 (300,000)
4 400,000 (300,000)

It is expected that the cash flows will differ because of inflation. The annual rates of inflation are expected to be:
Equipment value: 4% per year
Revenue: 3% per year
Running costs: 5% per year.
The cost of capital is 12%.

Required
(a) Calculate the NPV of the project ignoring inflation.
(b) Calculate the NPV of the project allowing for inflation.

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