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%.
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)
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.
Apex Ltd is considering whether to invest in the purchase of a new machine costing GH¢250,000. The machine will have a four-year life and a net disposal value of GH¢100,000 at the end of Year 4.
In addition, GH¢38,000 of working capital will be required from the start of the project, increasing to GH¢50,000 at the beginning of the second year. All the working capital will be recovered at the end of Year 4.
The project is expected to generate extra annual revenues of GH¢200,000 and incur annual cash operating costs of GH¢80,000 for each year of the project. Apex Ltd’s cost of capital is 10% after tax.
Corporation tax is charged on profits at 35%. Tax is payable in the year following the year in which the profits occur. There will be a 25% annual writing-down allowance on capital expenditure, for tax purposes. The tax-allowable depreciation is calculated by the reducing balance method.
Required
Calculate the NPV of the project and state whether or not it should be undertaken.
CVB Ltd is considering whether to invest in new equipment costing GH¢600,000. The equipment is expected to have an economic life of five years and will have no disposal value at the end of Year 5 (and no disposal costs).
CVB’s after-tax cost of capital is 15%. Tax is charged at an annual rate of 35% and is payable in the year following the year in which the taxable profits arise.
The following forecasts relate to the project under consideration:
Year
GH¢000
1
2
3
4
5
Sales income
250
250
300
350
400
Direct materials
50
55
58
64
70
Direct labour
25
25
30
30
35
Total direct costs
75
75
88
94
105
Depreciation
120
120
120
120
120
There will be tax allowances on the cost of the equipment, calculated at 25% each year on the reducing balance basis. The first depreciation tax allowance (capital allowance) would be claimed in year 0 (or very early in year 1).
Assume that:
(1) taxable profits are defined as income minus direct costs and capital allowances
(2) cash profits in each year = sales minus direct costs
Required
Calculate the net present value of the project and recommend whether or not the project should be undertaken.
Zest Ltd is considering whether or not to invest in a four-year investment project. The project will require the purchase of equipment costing GH¢800,000. This will have an estimated residual value of GH¢200,000 at the end of Year 4. The equipment will be depreciated by the straight-line method.
The profits before interest and tax from the project are expected to be GH¢400,000 each year. Tax is payable at 30% one year in arrears.
The equipment will qualify for capital allowances (tax depreciation allowances) of 25% each year, using the reducing balance method. The first claim for an allowance would be made against Year 0 profits.
The after-tax cost of capital is 15%.
Required:
Calculate the NPV of the project.
Kumasi Motors Ltd, a manufacturer of car accessories, is considering a new product line. This project would commence at the start of Kumasi Motors Ltd’s next financial year and run for four years. Kumasi Motors Ltd’s next year-end is 31st December 2005.
The following information relates to the project:
A feasibility study costing GH¢8 million was completed earlier this year but will not be paid for until March 20X6. The study indicated that the project was technically viable.
Capital expenditure
If Kumasi Motors Ltd proceeds with the project, it would need to buy new plant and machinery costing GH¢180 million to be paid for at the start of the project. It is estimated that the new plant and machinery would be sold for GH¢25 million at the end of the project.
If Kumasi Motors Ltd undertakes the project, it will sell an existing machine for cash at the start of the project for GH¢2 million. This machine had been scheduled for disposal at the end of 20X7 for GH¢1 million.
Market research
Industry consultants have supplied the following information:
Market size for the product is GH¢1,100 million in 20X5. The market is expected to grow by 2% per annum.
Market share projections should Kumasi Motors Ltd proceed with the project are as follows:
20X6
20X7
20X8
20X9
Market share
–
0.07
0.09
0.15
Subcontractors
Some of the work on the project would be performed by subcontractors who would be paid the following amounts:
Year
20X6
20X7
20X8
20X9
Payments to subcontractors (GH¢ million)
10
12
15
15
Fixed overheads
Incremental fixed overheads (all cash expenses) will be GH¢5 million in each of the four years of the project.
Labour costs
At the start of the project, employees currently working in another department would be transferred to work on the new product line. These employees currently earn GH¢3.6 million. An employee currently earning GH¢2 million would be promoted to work on the new line at a salary of GH¢3 million per annum. A new employee would be recruited to fill the vacated position.
As a direct result of introducing the new product line, employees in another department currently earning GH¢4 million would have to be made redundant at the end of 20X6 and paid redundancy pay of GH¢6 million at the end of 20X7.
Material costs
The company holds a stock of Material X which cost GH¢6.4 million last year. There is no other use for this material. If it is not used, the company would have to dispose of it at a cost to the company of GH¢2 million in 20X6. This would occur early in 20X6.
Material Z is also in stock and will be used on the new line. It cost the company GH¢3.5 million some years ago. The company has no other use for it, but could sell it on the open market for GH¢3 million early in 20X6.
Further information
The year-end payables are paid in the following year.
The company’s cost of capital is a constant 10% per annum.
It can be assumed that operating cash flows occur at the year-end.
Time 0 is 1st January 20X6 (t1 is 31st December 20X6, etc.)
Required
Calculate the net present value of the proposed new product line (work to the nearest million).
Tema Electrical Plc is considering whether to purchase a machine for the manufacture of a new product, Product X. It has been estimated that Product X would have a life of four years and at a selling price of GH¢8 per unit, annual sales demand would be 400,000 units in Year 1, 600,000 units in Year 2 and 800,000 in each of Years 3 and 4.
Variable production and selling costs would be GH¢6 per unit. Incremental annual fixed cost expenditures (all cash cost items) would be GH¢500,000 in Year 1, rising by GH¢20,000 each year.
The machine, which has an annual output capacity of 700,000 units of Product X, would cost GH¢1,200,000 and would have a resale value of GH¢200,000 at the end of Year 4. Capital allowances would be available on a 25% annual reducing balance basis, with a balancing charge or allowance in the year of disposal. Tax at 25% is payable one year in arrears of the profits to which it relates.
Tema Electrical Plc is financed 70% by equity capital and 30% by debt capital. The equity has a cost of 10% and the debt has a cost of 8.9% (before tax).
Required
Calculate the net present value of the proposed project and recommend whether the investment in the machine should be undertaken.
