Topic: Discounted cash flow

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MA – Mar 2023 – L2 – Q4a – Discounted cash flow

Determine whether Arkoo Ltd's project is viable using the NPV method.

Question:
Arkoo Ltd (Arkoo) is planning to invest GH¢5 million in its sound engineering studio with a life span of 10 years. Arkoo charges GH¢5.50 for every compact disc (CD) produced with an associated cost of GH¢4.80. The company plans to produce 8,700,000 CDs each year. Arkoo evaluates all investment opportunities against a discount factor of 21%.

Required:
i) Determine whether the project is viable or not using the Net Present Value (NPV) method.
ii) Calculate the percentage by which the following conditioning factors of Arkoo must change
in order for NPV to be zero.

  • Selling price (3 marks)
  • Variable cost (3 marks)

  • Sales Volume (3 marks)
  • Initial investment (3 marks)

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MA – Nov 2019 – L2 – Q4a – Introduction to capital budgeting

Select the appropriate plant for Pagsana Company using Payback Period and NPV analysis.

a) Pagsana Company plans to introduce a new product line for production of its local drink in Walewale. The company, therefore, decided to acquire either a semi-automated plant or an automated plant. The relevant data for the two proposed plants are as follows:

Required:
i) Select the appropriate plant on the basis of:

  • Payback Period (4 marks)
  • Net Present Value

(7 marks)

ii) Explain TWO (2) advantages of discounted cashflow method of investment appraisal. (4 marks)

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MA – Aug 2022 – L2 – Q4a – Discounted Cash Flow

This question involves calculating the IRR to assess the viability of acquiring a new plant for Tanko Ltd.

Tanko Ltd (TL) is engaged in the manufacturing and sale of a single product GG. The existing manufacturing plant is being operated at full capacity of 6,000 units per annum, but the production is not sufficient to meet the growing demand of GG. TL is considering replacing its existing plant with a new Japanese plant. The production capacity of the new plant would be 50% more than the existing capacity. The board of TL considers this expansion a high-risk investment and requires a minimum expected rate of return of 15% on its investment.

To assess the viability of this decision, the following information has been gathered:
i) The purchase cost and installation cost of the new plant will amount to GH¢3.14 million and GH¢0.45 million, respectively.
ii) The supplier would send a team of engineers to Ghana for final inspection of the plant before commissioning at a cost of GH¢120,000. 50% of this cost would be borne by TL.
iii) As a result of the installation of the new plant, fixed costs other than depreciation would increase by GH¢0.3 million per annum.
iv) The existing plant has an estimated life of 10 years and has been in use for the last 6 years. The machine supplier has offered to purchase the existing plant immediately at GH¢1.6 million.
v) During the latest year, 6,000 units were sold at an average selling price of GH¢550 per unit. Variable manufacturing cost was GH¢450 per unit. TL expects to increase sales volume by 25% in the first year after the plant’s installation. Thereafter, the sales volume would increase by 4% per annum. Selling price and variable manufacturing cost will increase by 5% per annum.
vi) The new plant would be depreciated using the straight-line method. The residual value of the plant at the end of its useful life of 4 years is estimated at GH¢350,000.
vii) TL’s cost of capital is 12%.

Required:
Using break-even rate (internal rate of return), advise whether TL should acquire the new plant.

 

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MA – Mar 2024 – L2 – Q1b – Divisional performance | Discounted Cash Flow

This question explains why the divisional manager may reject an option with a higher NPV and discusses board acceptability.

The performance bonus of the fragrance divisional manager is linked to Return on Investment (ROI) and Residual Income (RI) and has an impact on the calculation of retirement benefits. The manager is due to retire at the beginning of Year 3.

Required:
Explain why the fragrance Divisional Manager will not invest in the option showing the higher NPV and comment on whether it will be acceptable to the Board

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MA – Dec 2023 – L2 – Q4a – Discounted Cash Flow

This question involves calculating the NPV for three projects being considered by Kanfa Ltd and recommending the best project based on financial grounds.

Kanfa Ltd received GH¢50 million as compensation from Ghana Highways Authority (GHA) when one of its properties was destroyed to pave way for the Accra–Kumasi highway construction. Management of Kanfa Ltd has decided to invest the amount received in one of three capital investment opportunities identified.

Project A:

This is a long-term project, which would run for 20 years and will require an immediate outlay of GH¢50 million and net annual cash profits as follows:

  • 1st to 5th years: GH¢2 million
  • 6th to 10th years: GH¢8 million
  • 11th to 15th years: GH¢15 million
  • 16th to 20th years: GH¢5 million

At the end of the 20th year, the project would be decommissioned at a cost of GH¢2 million.

Project B:

Kanfa Ltd is considering opening a Tourist Attraction Centre in Cape Coast, with an initial capital investment of GH¢50 million. It will operate for five years and be sold at an estimated price of GH¢5 million. The market research survey estimates the following visitor numbers and probabilities:

  • 800,000 visitors (30%)
  • 600,000 visitors (50%)
  • 400,000 visitors (20%)

Entrance fee: GH¢40 per visitor, and each visitor is expected to spend GH¢15 on souvenirs and GH¢5 on refreshments. Variable costs per visitor: GH¢25 (including souvenirs and refreshments). Maintenance costs: GH¢2 million per annum.

Project C:

This project involves a current outlay of GH¢50 million on equipment and GH¢15 million on working capital immediately. The working capital will increase to GH¢21 million in year one. Net annual cash profits: GH¢18 million for six years. The capital equipment can be sold for GH¢5 million at the end of the project.

Other information:

  • The company’s cost of capital is 12% for the three projects.
  • Ignore taxation and inflation.

Required:
Calculate the Net Present Value (NPV) of each project and recommend which project the company should undertake on financial grounds.

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MA – Nov 2017 – L2 – Q1a – Discounted cash flow

Calculate the net present value of a new software game investment project and provide commentary on the findings.

a) Agyasco Ltd, a software company has developed a new game “Lando” which it plans to launch in the near future. Sales volumes, production volumes and selling prices for “Lando” over its four-year life are expected to be as follows:

Financial information on “Lando” for the first year of production is as follows: Direct material cost GH¢5.4 per game Other variable production cost GH¢6.00 per game Fixed costs GH¢4.00 per game.

Advertising costs to simulate demand are expected to be GH¢650,000 in the first year of production and GH¢100,000 in the second year of production. No advertising costs are expected in the third and fourth years of production. Fixed costs represent incremental cash fixed production overheads. “Lando” will be produced on a new production machine costing GH¢800,000. Although this production machine is expected to have a useful life of up to 10 years, Government legislation allows Agyasco Ltd to claim the capital cost of the machine against the manufacture of a single product. Capital allowances will therefore be claimed on a straight-line basis over four years.

Agyasco Ltd pays tax on profit at a rate of 30% per annum and tax liabilities are settled in the year in which they arise. Agyasco Ltd uses an after-tax discount rate of 10% when appraising new capital investments. Ignore inflation.

Required: Calculate the net present value of the proposed investment and comment on your findings.

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MA – May 2018 – L2 – Q1a – Discounted cash flow

Compare the NPV of maintaining old equipment versus buying new equipment to advise management on the better option.

The Maintenance Manager of Prudence Ltd insists that management should maintain an old 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 Prudence Ltd should go for.

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MA – July 2023 – L2 – Q4a – Discounted cash flow

Calculate the cost of capital for a delivery van investment using IRR, and compare payback and discounted cash flow methods of investment appraisal.

a) Johnson & Co is a medium sized company that is engaged in delivery services. As a result
of the recent increase in the demand for services, the Managing Director (MD) is planning
for the future business performance. The MD plans to acquire a delivery van at the cost of
GH¢85,000. The expected net cash flow per year are as follows:

The Sales Manager has indicated to the MD that he will recoup his investment in less than four years and for that reason, it’s a good investment.

The Management Accountant has however drawn his attention to the fact that the manager has not factored time value of money and the cost of capital in his analysis. He could not however suggest the cost of capital since financial institutions are charging different interest rates.

Required:

i) Calculate the cost of capital when used would result in a break-even, when the useful life of the van is five years with residual value of GH¢8,500. (11 marks)

ii) Using TWO (2) points each, compare and contrast the payback method of investment appraisal and the discounted cash flow method.

(4 marks)

 

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MA – Nov 2020 – L2 – Q4a – Discounted Cash Flow

Calculate the cost of capital to break-even for a van investment over five years and discuss the advantages and disadvantages of the payback method.

a) Jayjay & Co is a medium-sized company that is engaged in delivery services. As a result of the recent increase in the demand for its services, the Managing Director (MD) is planning to acquire a delivery van at the cost of GH¢85,000. The expected net cash flow per year is as follows:

Year Net Cash Flow (GH¢)
1 25,000
2 28,000
3 39,000
4 34,000
5 24,000

The Sales Manager has indicated to the MD that the company will recoup its investment in less than four years, and for that reason, it’s a good investment. The Management Accountant, however, has drawn the MD’s attention to the fact that the Sales Manager has not factored in the time value of money and the cost of capital into his analysis.

Required:

i) Calculate the cost of capital that, when used, will make the investment break-even when the useful life of the van is five years with a residual value of GH¢8,500.
ii) Explain TWO (2) advantages and TWO (2) disadvantages of the payback method of investment appraisal and show how it compares to the discounted cash flow method.

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MA – May 2020 – L2 – Q4b – Discounted cash flow

Explain the elements that determine the time value of money and its importance in investment appraisal.

b) The main reason why discounted cash flow methods of investment appraisal are considered theoretically superior is that they take into account the time value of money.

Required:

Explain THREE (3) elements that determine the time value of money and why it is important to take them into consideration when appraising investment projects. (6 marks)

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MA – Nov 2018 – L2 – Q1a – Discounted Cash Flow

Assess the financial desirability of producing designer ceramic tiles by calculating the net present value in real terms.

Mawuena Ltd, a manufacturer of building materials, has recently suffered falling demand due to economic recession, and thus has unutilised capacity. Management has identified an opportunity to produce designer ceramic tiles for the home improvement market. It has already paid GH¢1.5 million for development expenditure, market research, and feasibility studies.

A new machine, with a useful life of four years, could be bought at GH¢6.5 million, payable immediately. The scrap value of the machine is expected to be 5% of the cost, recoverable a year after the end of the project.

The research and development division has prepared the following demand forecast:

Year 1 2 3 4
Demand (units) 110,000 130,000 150,000 145,000

The selling price is GH¢50 per box (at today’s price). Estimated operating costs, largely based on experience, are as follows:

Cost per box of tiles (at today’s price) GH¢
Materials cost 12.00
Direct labour 5.00
Variable overhead 2.50
Fixed overhead (allocated) 3.50
Distribution (Variable) 5.50

In addition to the initial cost of machinery, investment in working capital of GH¢0.2 million will be required in year two. Mawuena Ltd pays tax one year in arrears at an annual rate of 30% on returns from the project. Mawuena Ltd shareholders require a nominal return of 14% per annum after tax, which includes allowance for generally expected inflation of 5.55% per annum. (Ignore Capital Allowance).

Required:
Assess the financial desirability of this venture in real terms, computing the net present value offered by the project. (14 marks)

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MA – Nov 2021 – L2 – Q4b – Discounted Cash Flow

Discuss non-financial factors that Bee Ltd should consider before outsourcing production.

b) Bee Ltd could outsource the production of Ohenewa to an overseas manufacturer. The Accountant has presented figures to show that the NPV of the project based on outsourcing the production is GH¢0.5 million higher than the positive NPV of in-house production.

Required:
Explain THREE (3) non-financial factors that Bee Ltd would need to consider before making the decision either to outsource or produce in-house. (3 marks)

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MA – Nov 2021 – L2 – Q4a – Discounted Cash Flow

Calculate and evaluate the payback period for the Ohenewa project based on provided cash flows.

a) Bee Ltd manufactures high-quality mobile phones for its local market. Due to less competition, Bee Ltd sales have grown significantly over the past few years and are expected to grow. Bee Ltd is planning to launch a new model, ‘Ohenewa’.

The company has already spent GH¢1 million on Research and Development and will require a further investment of GH¢5.5 million in production equipment. This cost excludes the GH¢1.1 million installation fee. The project has a life span of five years. In the end, the equipment will have a residual value of GH¢0.6 million. Sales and production of Ohenewa over its lifecycle are expected to be:

Year Units
1 6,500
2 7,500
3 8,000
4 7,800
5 7,000

The selling price in Year 1 and Year 2 will be GH¢750 per unit. However, the selling price will be reduced to GH¢600 per unit in Year 3 and will remain at this level for the remainder of the project. The variable cost as a percentage of sales is 55% over the entire product lifecycle. The fixed overhead, including depreciation cost expected to be incurred directly due to increasing the production capacity, is GH¢2 million per annum.

Other information:

  • A cost of capital of 12% per annum is used to evaluate projects of this type.
  • Bee Ltd has a history of accepting similar projects which pay back within three years.
  • Ignore inflation and taxation.

Required:
i) Calculate the Payback Period for the Ohenewa project. (10 marks)
ii) Evaluate the acceptability of the project based on the calculation in i) above. (2 marks)

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MA – May 2021 – L2 – Q4b – Discounted cash flow

Identify and explain two advantages of the Net Present Value technique

b) Identify and explain TWO (2) advantages of the Net Present Value technique. (3 marks)

 

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MA – April 2022 – L2 – Q4a – Discounted cash flow

Evaluate the acceptability of a project using the Net Present Value (NPV) method considering cash flows and cost of capital.

Phil Company is considering replacing its existing machine on the introduction of a new product. The existing machine would be sold for GH¢2 million and replaced with a new machine at the beginning of the year at the cost of GH¢16 million. This new machine would be sold at the end of year 4 for GH¢1 million.

A market research recently carried out at a cost of GH¢1.5 million indicates a unit selling price of GH¢300 in year 1, rising by 10% per annum. Sales volume for the four-year life of the project has been estimated as follows:

Year Units
1 60,000
2 85,000
3 85,000
4 80,000

Possible unit variable costs are as follows:

Probability GH¢
0.4 240
0.6 260

Incremental fixed cost as a result of the project is GH¢15 per unit plus GH¢1,000,000 per annum staff cost.

The introduction of the new product is expected to reduce the market demand for an existing product by 5,000 units per annum. The existing product has a unit contribution of GH¢75.

Other annual fixed costs associated with the new product include the following:

  • Amortization of goodwill: GH¢50,000
  • Depreciation: GH¢250,000

Phil Company’s cost of capital is 12%.

Required:

Evaluate the acceptability of the project.

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MA – May 2021 – L2 – Q4a – Discounted cash flow

Evaluate two machines using Net Present Value and Discounted Payback Period methods to determine the preferred investment.

a) Oseikrom Ventures is considering minimising its production cost through automation of its production system. Two machines are being considered to save cost. The estimated data for the two machines available on the market are as follows:

Machine A (GH¢’000) Machine B (GH¢’000)
Initial cost (Year 0) 120,000 120,000
Residual value (Year 5) 20,000 30,000
Working capital requirement (Year 0) 15,000 10,000

Annual cost savings:

Year 1 2 3 4 5
Machine A 40,000 40,000 40,000 20,000 20,000
Machine B 20,000 30,000 50,000 70,000 20,000

The company’s cost of capital is 10%.

Required:
Using the following methods, which machine should be selected?
i) Net Present Value (8 marks)
ii) Discounted Payback Period (4 marks)

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MA – May 2016 – L2 – Q2a – Discounted Cash Flow, Decision Making Techniques

Discuss the justifications for the popularity and limitations of Payback Period and ARR as investment appraisal techniques.

It is said that of all the capital investment evaluation approaches, the Payback (PB) and Accounting Rate of Return (ARR) methods are widely used in practice. But these methods are not without limitations.

Required:

i) State TWO justifications of Payback Period and ONE justification of ARR for their popularity in practice as investment appraisal techniques.
(3 marks)

ii) Outline TWO limitations each for Payback Period and ARR as investment appraisal techniques.
(4 marks)

 

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MA – Nov 2016 – L2 – Q5a – Discounted cash flow

Calculate the NPV break-even point under different cost of capital scenarios and determine the project's duration based on given cash inflows.

DDB Limited has decided to set up a factory to process groundnuts into oil. The feasibility studies cost them GH¢35,000. The consultants have advised that the initial outlay will be GH¢250,000; however, they were unable to estimate the cash inflow due to the uncertain economic environment.

Required:
Using NPV as an appraisal technique, you are required to calculate:

i) The constant cash inflow needed to break even if the cost of capital is 15% and the project is to last for 10 years.

(4 marks)

ii) By how much should the cash inflow increase to break even if the cost of capital is increased to 20%. (4 marks)

iii) If the cash inflow is GH¢45,000, for how long should the project run to break even if the cost of capital is 15%.

(4 marks)

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FM – DEC 2023 – L2 – Q3 – Discounted cash flow | Sources of finance: debt | Working Capital Management

Identification of cash flow patterns, present value calculation for two payment strategies, and explanation of the benefits and factors related to credit rating.

a) TekApps is a small technology company that develops financial technology (FinTech) applications for mobile devices. The company is selling one of its highly rated FinTech apps to a financial institution. The financial institution has proposed the following strategic payment options for TekApps’ consideration:

Strategy 1: An immediate payment of GH¢1.2 million followed by payments of GH¢50,000 at the end of each quarter during the next five years.

Strategy 2: Payment of GH¢55,000 at the beginning of each month for the next five years.

TekApps’ required rate of return is 25% per annum.

Required:
i) Identify the type of cash flow pattern described under each option. (3 marks)
ii) Compute the present value of the cash flows for each strategy and advise TekApps on the best payment option. (7 marks)

b) BKB Entertainment Ltd (BKB) currently borrows at an average rate of 24% per annum. The Treasury Manager of the company believes that BKB can borrow at a lower interest rate if its creditworthiness is assessed and rated by a rating agency. He has therefore recommended to the Board of Directors to consider requesting a credit rating.

Required:
i) Explain TWO (2) benefits of credit rating to BKB. (4 marks)
ii) Advise the directors on THREE (3) factors rating agencies will consider in determining the company’s credit rating. (6 marks)

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FM – Nov 2020 – L2 – Q3a – DCF: Specific applications | Discounted cash flow

Calculate the present value of payments under cash and credit purchase options, and recommend the better option.

The directors of PDS Foods Ltd (PDS) are considering two payment options for the purchase of a new cereal processing plant:

Option 1: Cash purchase option
This option requires immediate payment of the full price of the plant. If PDS chooses this option, it will pay the cash price of GH¢800,379 today. PDS plans to raise the required amount by borrowing from a bank. Conso Bank Ghana has offered to lend the cash price to PDS at an annual interest rate of 15% with monthly compounding. The loan, interest, and other charges are to be amortized by even instalments of GH¢27,952.26 each made at the end of each month over the next three years.

Option 2: Credit purchase plan
Under this option, the vendor requires an immediate down payment followed by a series of even payments. If PDS chooses this option, it will be required to pay GH¢50,000 today. This will be followed by the payment of GH¢116,100 at the end of each quarter over the next two years. The interest rate implicit in this credit purchase plan is 20% per annum.

Required:

i) Find the present value of all the payments under the cash purchase option. (5 marks)
ii) Find the present value of all the payments under the credit purchase option. (4 marks)
iii) Which of the two options do you recommend to the company? Explain. (1 mark)

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