EDC- FM-INVESTMENT APPRAISAL

INVESTMENT APPRAISAL

1. In a review of a project with a large initial cash outflow followed by a few years of cash inflows
that has a positive NPV, the cash inflows are shifted to 1 year later than originally predicted and
the cost of capital used for discounting the project is reduced by 1%.

What are the effects of these changes on the project NPV?

A. cash flows – lower NPV, cost of capital – lower NPV

B. cash flows – lower NPV, cost of capital – higher NPV
C. cash flows – higher NPV, cost of capital – lower NPV
D. cash flows – higher NPV, cost of capital – higher NPV

2. Which of the following statements about net present value (NPV) and internal rate of return
(IRR) methods are correct?

(i) An investment with a positive NPV is financially viable

(ii) NPV is a superior method of investment appraisal to IRR

(iii) The graph of NPV against discount rate has a negative slope for most projects

(iv) NPV is the present value of expected future net cash receipts less the cost of the investment

A. (i) and (ii) only

B. (ii) and (iv) only
C. (i), (ii) and (iii) only
D. (i), (ii), (iii) and (iv)

3. Which of the following is not an advantage of the IRR?

A. It considers the whole life of the project.
B. It uses cash flows not profits.
C. It is a measure of absolute return.
D. It considers the time value of money.

4. Sarah Co is evaluating Project J, which requires an initial investment of $50,000. Expected net
cash flows are $20,000 per annum for four years at today’s prices. However, these are expected
to rise by 5.5% pa because of inflation. The firm’s money cost of capital is 15%.

Find the NPV by:

(a) discounting money cash flows

(b) discounting real cash flows.

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5. Project Y has the following cash flows before allowing for inflation, i.e. they are stated at their Y0
values.

The company’s money discount rate is 15.5%. The general rate of inflation is expected to remain
constant at 5%.

Year Cash flow ($)

0 (750)
1 330
2 242
3 532

Evaluate the project in terms of:

(a) real cash flows and real discount rates

(b) money cash flows and money discount rates

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6. Brian is considering a cost-saving project. This involves purchasing a machine costing $7,000,
which will result in annual savings (in real terms) on wage costs of $1,000 and on material costs
of $400.

The following forecasts are made of the rates of inflation each year for the next five years:

Wage costs: 10%

Material costs: 5%

General prices: 6%

The cost of capital of the company, in real terms, is 8.5%.

Evaluate the project if the machine has a life of five years and no scrap value.

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7. An equipment is bought for $10,000 and will be used on a project for four years after which it
will be disposed of. Tax is payable at 30%, one year in arrears, and tax-allowable depreciation is
available at 25% reducing balance.

Required:

a) Calculate the tax-allowable depreciation and hence the tax savings for each year if the
proceeds on disposal of the asset are $2,500.
b) How would your answer change if the asset were sold for $5,000?
c) If net trading income from the project is $8,000 pa, based on your answer to part (a) and a
cost of capital of 10%, calculate the NPV of the project.

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8. Darren Ltd expects sales for a new project to be $225,000 in the first year growing at 5% pa. The
project is expected to last for 4 years.

Working capital equal to 10% of annual sales is required and needs to be in place at the start of
each year.

Calculate the working capital flows for incorporation into the NPV calculation.

9. Betty anticipates sales for the latest venture to be 100,000 units per year. The selling price is
expected to be $3 per unit in the first year, inflating by 8% pa over the three-year life of the
project.

Working capital equal to 10% of annual sales is required and needs to be in place at the start of
each year.

Calculate the working capital flows.

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10. Archie Co is considering a potential project with the following forecasts:

Now Y1 Y2 Y3
Initial investment ($million) (1,000)

Disposal proceeds ($million) 200

Demand (millions of units) 5 10 6

The selling price per unit is expected to be $100 and the variable cost $30 per unit. Both figures
are given in today’s terms.

Tax is paid at 30%, one year after the accounting period concerned.

Working capital will be required equal to 10% of annual sales. This will need to be in place at the
start of each year.

Tax-allowable depreciation is available at 25% reducing balance.

The company has a real required rate of return of 6.8%.

General inflation is predicted to be 3% pa but the selling price is expected to inflate at 4% and
variable costs by 5% pa

Determine the NPV of the project.

N.B. work in $ millions and round all numbers to the nearest whole million.

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11. Project A has an annual net cash inflow (in current terms) of $3 million, occurring at the end of
each year of the project's two-year life. An investment of $3.5 million is made at the outset. All
cash inflows are subject to corporation tax of 30%, payable when the cash is received.

There is no tax-allowable depreciation on the initial investment. An average inflation rate of 5%

per annum is expected to affect the inflows of the project.

The cost of capital in money terms is 15.5%

What is the expected net present value of the project (to the nearest $100,000)?

A. $93,000
B. $147,000
C. $287,000
D. $367,000

12. Machine Z costing $40,000 is expected to last for three years, after which can be sold for
$16,000. The corporation tax rate is 30%, taxallowable depreciation at 25% is available, and the
cost of capital is 10%. Tax is payable at the end of each financial year.

Capital expenditure occurs on the last day of a financial year, and the tax-allowable depreciation
is claimed as early as possible.

What is the cash flow in respect of tax-allowable depreciation that will be used at time 2 of the
net present value calculation?

A. $1,688
B. $2,250
C. $5,624
D. $7,500

13. Project 1 is expected to generate sales of 55,000 units per year. The selling price is expected to
be $3.50 per unit in the first year, growing at 6% pa. The project is expected to last for three
years.

Working capital equal to 12% of annual sales is required and needs to be in place at the start of
each year.

What is the cash flow in respect of working capital that will be used at time 2 of the net
present value calculation?

A. $(25,955)
B. $(24,486)
C. $(1,386)
D. $(1,469)

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14. Kelly Ltd has decided to acquire a new machine to dispose the toxic waste produced by its
refining plant. The machine would cost $6.4 million and would have an economic life of five
years.

Tax-allowable depreciation of 25% pa on a reducing balance basis is available for the investment.

Taxation of 30% is payable on operating cash flows, one year in arrears.

Kelly intends to finance the new plant by means of a five-year fixed interest loan at a pre-tax cost
of 11.4% pa, with the principal repayable in five years’ time.

As an alternative, a leasing company has proposed a lease over five years at $1.42 million pa
payable in advance.

Scrap value of the machine under each financing alternative will be zero.

Evaluate the two options for acquiring the machine and advise the company on the best
alternative.

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15. A machine costs $20,000.

The following information is also available:

Running costs (payable at the end of the year):

Year 1: $5,000

Year 2: $5,500

Trade-in allowance:

Disposal after 1 year: $16,000

Disposal after 2 years: $13,000

Calculate the optimal replacement cycle if the cost of capital is 10%.

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16. Joelle needs be made on replacement policy for trucks. A truck costs $12,000 and the following
additional information applies:

Asset sold at end Trade-in allowance Asset kept for Maintenance cost at end
of year of year
($) (Year) ($)
1 9,000 1 0
2 7,500 2 1,500 in 1st year
3 7,000 3 2,700 in 2nd year

Calculate the optimal replacement policy at a cost of capital of 15%.

Note: The asset is only maintained at the end of the year if it is to be kept for a further year, i.e.
there are no maintenance costs in the year of replacement.

Ignore taxation and inflation.

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17. Yorkie has $100,000 available for investment and has identified the following 5 investments in
which to invest. All investments must be started now (Yr 0).

Project Initial investment @ Yr 0 NPV

($000) ($000)
C 40 20
D 100 35
E 50 24
F 60 18
G 50 (10)
Required:

a) Determine which projects should be chosen to maximise the return to the business if the
projects are divisible.
b) Determine which projects should be chosen to maximise the return to the business if the
projects are indivisible.
c) Determine the optimal project selection if projects C and E are mutually exclusive and others
are divisible.

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